Direct lending was on a roll pre-covid, with fundraising climbing year after year. Investors were persuaded by the rationale for the market – that the asset class had stepped into the corporate lending gap left by the banks’ retrenchment following the global financial crisis. Existing exposures were ramped up and new limited partners joined the party.

There was nothing to spoil direct lending’s trajectory until covid-19 came along. But what about now? Does the crisis open up yet more opportunity or is it the moment when the emperor is revealed to be lacking clothes?

Ari Jauho, partner and chairman at Helsinki-based fund of funds Certior Capital, has been looking for clues. His firm has mid-market direct lending exposure through separate accounts and advisory relationships with Finnish institutions. Since 2015, the direct lending mandates have shrunk a little but Jauho says this is due to institutions merging rather than covid.

In April, as the first wave of the virus was peaking in Europe, Certior analysed the prospects of more than 200 companies in its funds to gauge how badly covid would hit them on a low-, medium- and high-impact basis. The firm concluded that 23 percent of its private debt portfolio companies were subject to a high impact, compared with 17 percent of its private equity portfolio businesses. Unsurprisingly, the most vulnerable companies were in sectors such as retail, hospitality and travel.

What investors are examining closely is managers’ ability to guide their portfolio companies through any issues they may face. Managers may have had to boast of their operational capabilities when raising funds, and now is the time when the skills they claimed to have are being put under the microscope.

Abhik Das, head of private debt at Munich-based Golding Capital Partners, a specialised asset manager focused on alternatives, thinks the private debt arms of private equity firms may come into their own: “There are differences in the models and that is likely to be reflected in the performance data. Some LPs have shied away from private debt funds that are part of private equity-focused managers, largely due to conflicts, but ultimately it’s all about how these conflicts are managed. One thing we’ll see is how some of the private equity-backed debt funds will be able to manage portfolios in a better way as they can lean on their private equity colleagues for practical help when difficulties arise.”

Das says Golding divides its private debt exposure between direct lending – which accounts for around two-thirds of total exposure – and opportunistic credit. The direct lending bucket includes subordinated debt, extending from hybrid capital solutions to traditional large-cap mezzanine funds, though he says Golding was already increasing its allocation to senior-oriented direct lending before the pandemic. The senior segment accounted for around 50-60 percent of the firm’s private debt commitments in 2018 and 2019.

Keeping it in the family

Apolis may be concerned about monetary policy, but its appetite for direct lending has not diminished

Apolis is an experienced direct lending investor that has sourced its own deals and made co-investments with funds and other family offices. The firm is upbeat about the prospects for direct lending, notwithstanding the economic turbulence.

“I would say covid had no influence on our appetite for direct lending and the ways we invest,” says managing principal Evgeny Denisenko. “Apolis’s portfolio of loans hasn’t experienced any defaults or restructurings triggered by covid – in part, perhaps, because we started to prepare for the market turbulence way in advance by avoiding business cycle-sensitive investments.”

The Monaco-based family office has been cautious about lending to real estate or commodity-related deals and has reduced its risk limits for these transactions. However, Denisenko says: “We are still monitoring these sectors as I believe there might be deeply underpriced opportunities in the near future.”

The pandemic has not acted as a barrier to Apolis seeking out new lending opportunities either, with two deals funded since March. Yet although the firm believes the fundamentals of direct lending are good, there is concern about the response of policymakers and the impact it will have on fixed-income markets.

“We are concerned with monetary policies in Europe and, to a lesser extent, across the Atlantic,” says Denisenko. “Existing levels of interest rates and the hunt for yield among investors will further reduce the availability of good quality deals and will reduce returns in general.”

Can you run the business?

Rohit Kapur, pensions investment research manager at UK energy and services company Centrica, thinks Das has a “valid point” about private debt units associated with private equity firms. “You could see that having that resource would be helpful,” he says.

“Resourcing is particularly important when lenders have to take the keys to the business. That’s very resource-intensive. Even if you only have one or two defaults, it will still take a lot of management time. What about when there are more than one or two? Do you have the internal resource to run those companies? Are you drawing resource away from performing loans and from the origination of new deals?”

Kapur says Centrica steered away from direct lending in the run-up to the pandemic and has not committed to a European direct lending fund for around four years. “The reason for that was a surplus of capital, which has only increased over time,” he says. “There was a lot of dry powder and we were concerned about the impact of that on underwriting and returns going forward. We’ve seen returns compression over the last couple of years and that has been a consequence of the amount of capital in the market.”

Looking beyond whatever difficulties may lurk in portfolios, there is a feeling that the new deal environment is promising. “The overall risk-adjusted return is better,” says Das. “Given the uncertain environment, the risk appetite has diminished somewhat. Leverage levels have come down and most funds have been able to benefit from better pricing and documentation. However, it should also be noted that situations involving strong credit characteristics, such as software companies with a high degree of recurring revenues, have remained very competitive.”

“Events like covid and other dislocations in credit tend to help differentiate between strong performers and the rest”
Rakesh Jain

“No high-risk covid-19 companies are able to be financed now,” says Jauho. “You want less risky, less cyclical businesses financed with the same underwritten returns as in the past. The documents are stronger and businesses are more robust and covid-19-resilient than in the past. On the other hand, more people are chasing fewer deals.”

Earlier this year, Munich-based YIELCO closed its latest private debt fund of funds with €675 million. The vehicle is pursuing a conservative investment strategy that aims to provide risk-averse investors with access to the asset class.

Managing director Matthias Unser says existing portfolio investments remain relatively stable, notwithstanding the challenging environment: “Our portfolio valuations have held up very well so far and we have not yet seen any payment defaults, although a significant proportion of the portfolio has seen covenant amendments or waivers. We expect to see more issues in the course of 2021 but are convinced senior loans should do relatively well even then.”

He believes fund managers have been active and transparent in terms of portfolio management and the measures taken to deal with portfolio companies that are struggling as a result of the pandemic. Unser is positive about the future. Although he expects investments from 2019 and the early months of 2020 to underperform relative to benchmarks, with serious underperformance for managers that were too aggressive before the crisis, he also believes that investments made since March will outperform long-term benchmarks.

Under and out

“We continue to see direct lending as an attractive asset class and therefore carry on with our commitment plans without any major changes,” he says. “While we have not seen a big shift in pricing and terms for healthy companies, the competitive dynamics overall are favourable for direct lending funds post-covid-19, since banks are more conservative again and the capital needs of companies have already increased and will continue to increase.”

Although Unser expects an improved environment for lenders in the months ahead, he says the large amount of dry powder in the market and the strong appetite for direct lending among institutional investors will counteract this somewhat: “I only expect slightly better pricing of around 50-100 basis points and better terms such as 0.5-1.0x lower leverage and, overall, less aggressive terms in areas such as EBITDA adjustments.”

Another bullish assessment of the market’s prospects comes from Al Alaimo, senior fixed-income portfolio manager at the Arizona State Retirement System. “We’re very pleased with the performance of our private debt portfolio through the covid crisis,” he says. It has “held up very well” and has “substantially outperformed our benchmark” of the S&P LSTA Leveraged Loan Index, plus 2.5 percent.

Although the index fell 12.5 percent in March, Alaimo says the pension fund’s portfolio fell by less than 1 percent. As of 31 August, the allocation to private debt strategies – mostly direct lending in performing credit – comprised 14.4 percent of the pension’s $42 billion under management. He thinks the allocation will increase to about 16 percent in the next two years.

Alaimo plans to increase the fund’s allocation to private credit, given that the market opportunity “has improved”. After the outbreak of the pandemic, the all-in yield on loans, including interest and upfront fees, has been about 1-1.5 percent higher than it was before covid. He thinks that returns from the pension’s private credit investments will improve because the underlying loans have higher expected returns and less risk.

“Our investment managers are telling us that they’re seeing significantly improved structures and documentation” in the loans, meaning they’re getting “higher returns with less risk” Alaimo says. He notes that the fund’s managers are “leaders in their respective markets” and “typically have stronger documentation than their competitors”.

He also believes the story in private debt has not changed: “It’s probably the best risk-adjusted return in the fixed-income markets.” While the high-yield market is yielding between 5.5 and 6.0 percent, new issues of private debt are yielding 8-10 percent, including fees. Marcus Frampton, chief investment officer of the Alaska Permanent Fund, says the fund has not increased its allocation to private income, which constitutes about 9 percent of the $65 billion it has under management. Private credit, which falls under the private income category, comprises around $1.5 billion of the fund’s total assets under management.

“We commit about a few hundred million dollars a year to private credit, most of it direct lending,” he says.

‘Flush with cash’

The private debt markets, like those for most asset classes, became overheated before covid. Although a lot of money went into private credit, “we’re in a world that is flush with cash”, says Frampton. In direct lending, “people are still committing to funds” and, given how much money there is out there, “at some point it has to flow into impaired portfolios”.

Although he says people are making the argument that perhaps too much money went into private debt, the stock market “has only been as expensive as it is today in 1929 and 2000”. He believes public equity is only likely to deliver annual returns of 2-3 percent for the next 10 years.

In an emailed response to our questions, the New York State Retirement System says it has committed “very little in the way of a dedicated direct lending strategy” and has one manager relationship.

However, the pension is looking at possibly increasing its exposure to direct lending strategies. It says the prospects for direct lenders are varied, depending on the quality of covenants and sectors that are lent to. It also believes that documentation standards should be more thoroughly scrutinised and that the number and quality of covenants should be on the rise. Pantheon is an LP with direct lending exposures in North America and Europe via selected GPs. The London-headquartered fund of funds manager had raised $800 million for its Global Private Debt Fund series as of September, according to two filings with the US Securities and Exchange Commission.

Rakesh Jain, a New York-based partner at Pantheon and global head of the private debt team, initially worked with European senior credit-focused funds. “We were pleased with performance, which was generated in our view by targeting discounted, seasoned portfolios – often backed by experienced private equity firms with conservative portfolio company leverage and high levels of diversification across recession-resilient, non-cyclical industries,” he says. “So we were not largely impacted by sectors such as travel, restaurants, retail or energy.”

“I only expect slightly better pricing of around 50-100 basis points and better terms such as 0.5-1.0x lower leverage and, overall, less aggressive terms in areas such as EBITDA adjustments”
Matthias Unser

However, in the first quarter of 2020, Jain’s team observed that many senior direct lending funds’ returns had contracted by 200-500 basis points. This was due to a number of factors, including industry exposures, how much leverage they employed at the fund level and what part of the market they invested in. He adds that, in the second quarter, most funds, though not all, had rebounded by approximately the same amount.

“At this time, I think a lot of direct lenders have not yet changed their expectations in terms of what returns they ultimately expect to deliver on these vintage-year portfolios,” he says. “Lenders believe that post-covid fees, spreads and returns should be higher, closing deal leverage should be lower, and terms and documentation better. So I think most direct lenders would say the investing environment post-covid, if you have the capital, will be much improved. But I think there is a real question as to how sustainable that will be, given the competitive environment.”

Shrouded in uncertainty

Jain says it remains to be seen how lenders and credit portfolios will perform over the next three quarters because there is still considerable uncertainty around the macroeconomic environment as well as consumer and business confidence.

“In general, this part of the private credit market will continue to attract meaningful amounts of capital due to the attractive yield that can be obtained,” he says. “Events like covid and other dislocations in credit tend to help differentiate between strong performers and the rest. You would expect to see some managers experience challenges in terms of the returns their investors expect. Lenders with advantages in scale, capital, team continuity, strong credit culture and deft portfolio management skills will continue to be partners of choice for sponsors and non-sponsors.”

Many LPs in Asia-Pacific have built up their mid-market lending investment portfolios by allocating capital to North American and European strategies. Due to the pandemic, however, some LPs have faced difficulties in conducting due diligence trips and hiring new private debt managers. Dong Hun Jang, chief investment officer at the Public Officials Benefit Association, says the Seoul-based institution has not been able to issue any requests for proposals for new private debt GPs this year.

He notes that before covid, returns generated by private debt funds were either meeting or surpassing expectations. He adds that “during the early days of the pandemic, the valuation levels of some assets temporarily dropped to a degree”.

POBA has not disclosed details of its return target for direct lending strategies, but says it plans to achieve an overall investment portfolio return rate of 4.1 percent by 31 December. In the eventual post-covid world, Jang says his team expects to see an increase of about two to three percentage points in actual return rates, after taking into account the higher upfront fees charged to borrowers.

Many observers remain bullish about direct lending’s prospects in the months and years to come. There is plenty of dry powder and no shortage of deals to be done. Moreover, with documentation showing signs of becoming a little more lender-friendly, there may even be improved returns on offer for those that stay the course.

There remain question marks, however, over the number of portfolio company defaults that will arise as a result of covid-related trading difficulties. Some managers will find the new deal market hard to take advantage of as they wrestle with more pressing issues – and raising that next fund may seem a long way away, if it ever happens at all.

The time is right for newcomers

With incumbent firms distracted by portfolio issues, technology platforms and start-ups may force their way into the market

“It may only take one default to make you a busted flush,” a market source tells us. The comment speaks to the precariousness of direct lending funds with relatively few individual loan positions and a return profile that simply doesn’t allow for too many failures before the strategy becomes unattractive.

In the good times that prevailed following the global financial crisis, this potential Achilles heel went untested. Covid has served as a painful reminder that good times do not last forever.

With many of the established direct lenders eyeing their portfolios nervously, and funnelling more capital to those in need, less attention is being given to the possibility of doing new deals. This in turn is creating a possible opportunity for newcomers to direct lending.

One trend is the continuing growth of ‘private debt 2.0’ platforms. These have typically targeted smaller loans than private debt firms are interested in. They have also used technology to quickly and efficiently identify suitable borrowers and have built up large portfolios. Some of these firms, which have often received institutional investment at the company level, are now using those institutional relationships to expand into raising direct lending funds.

One example was the first close of German platform creditshelf’s debut direct lending vehicle, backed by the European Investment Fund. The firm says it saw loan requests increase 69 percent in the first quarter of this year compared with the first quarter of 2019, and that sees an opportunity to capitalise on both ‘traditional’ direct lenders and the fact that banks are preoccupied with existing clients.

Up to now, funds raised by 2.0 firms have been few and far between. However, the likes of Assetz Capital, Funding Circle and October have gone down this route and others may be expected to follow.

John Bakie, Robin Blumenthal and Adalla Kim contributed to this report