How direct lending’s growth is changing returns

Jess Larsen of First Avenue charts the evolution from ‘idiosyncratic alpha’ to cost-efficient beta, and the impact this is having on fees.

Jess Larsen

The private credit industry continues to show strong growth. Surveys show that private debt will hit $1.4 trillion by 2023, passing real estate in becoming the third-largest alternative investment asset class after hedge funds and private equity. This growth is coinciding with LPs broadening their focus beyond direct lending to credit opportunities and asset-backed lending.

It’s vital to realize what’s driving this. A good example is provided by how the private equity market grew via allocations from public equity portfolios. With private credit, we are still in the early stages of a much bigger allocation out of public fixed income portfolios.

Unsurprisingly, rising capital flows have coincided with an influx of new managers. Today there are about 660 managers globally with about 60 percent based in North America; growth remains vibrant there as well as in Europe and Asia.

Changing return drivers

Yet it is becoming apparent that the industry’s long expansion since the Global Financial Crisis forced banks to curtail lending is beginning to change the dynamic of how investment returns are generated. Put simply, private credit is moving from a period when returns were a product of idiosyncratic ‘alpha’ to a new era characterised by a more cost-efficient direct lending beta type performance stream.

What is driving this transformation is straightforward.

Despite the emergence of hundreds of new debt managers, capital inflows have disproportionately benefited the largest GPs. In 2017, for example, the top 10 private debt firms received nearly one-third of the new capital deployed – leaving over 600 managers to share the rest. In the direct lending sector, the inflows are even more skewed with the top 10 GPs receiving over 50 percent of capital raised in recent years.

Capital inflows moderating

Inflows of capital to private credit continue to rise even though the pace of the increase is moderating. This is altering the private credit industry’s competitive dynamic as lenders increasingly become price takers rather than value-adding packagers of complex negotiated loans in the sponsored sector. In fact, GPs’ underwriting skills are becoming more critical than their structuring skills. The result is a more price sensitive and efficient, but less customised, market where GPs produce ‘alpha by avoidance’.

The natural progression in this type of business environment is persistent pressure on fees. With management fees, private credit has undergone a near universal transition to a levy on invested capital and away from one on committed funds. The preferred rate for a private credit fund to earn an incentive fee has also inched higher to a typical level of 7 percent from 6 percent not so long ago.

Another area of change is origination fees. Among the hundreds of private credit GPs we have met in recent quarters, the vast majority either share or fully pass on their origination fees. A handful of managers may still retain these fees, but the direction of travel is clear.

Macro uncertainty

These factors – slowing inflow growth into direct lending, the continuing entry of new managers and fee erosion – reflect private credit’s maturing as an asset class. Now, however, the macro environment is shifting with tightening monetary policy beginning to impose itself on the credit cycle. One consequence of this is that we expect the current benign default rate to edge higher. Our own estimate, based on First Avenue’s global private credit involvement, is that a reversion to average long-term historical default rates of 3.0-4.0 percent (vs. 1.5-2.0 percent currently ex-PG&E) is a reasonable base case scenario.

Given the potential for greater return volatility, we believe LPs will become more selective and gravitate towards larger and more established managers that provide platforms of scale, longer track records and brand recognition. We expect this flight to safety to further tighten direct lending spreads and reduce risk-adjusted returns. The outcome is likely to be further compression of the performance differentials among top-quartile and median-quartile funds that has become evident in recent years.

Efficient beta

With less variation in GP investment returns, it is likely that investors will increasingly perceive direct lending returns to be a beta play, further pressuring fees. This will have a knock-on effect in other areas.

It is our view that consultants and LPs will prioritise much longer track records extending over multiple cycles. The preference for low loss rates over an outperforming track record – or ‘alpha by avoidance’ – will further enhance the tendency towards uniform performance. For LPs, the investment outcome will be a more cost-efficient and predictable direct lending beta type performance stream.

Yet even though direct lending and private credit performance will be increasingly comprised of beta characteristics, investors will still need to choose how much risk they want to take and what level of diversification will be needed to ensure this. The upshot of alpha being pushed to the margin as the private credit asset class matures is likely to be greater competition among GPs and growing sophistication among LPs in their selection of different debt instruments with varying risk profiles.

Jess Larsen is partner, Head of the Americas, at First Avenue Partners.