Expanding horizons: Why it’s time to look beyond direct lending

Fundraising may have slowed, but US private debt still looks resilient.

Fundraising and M&A may be at their most sluggish for some time, but US private debt managers continue to notch up some of their best vintages ever. Bank retrenchment is creating opportunities, and the more conservative credit terms favour debt funds, fund managers say.

Horizons are expanding as GPs look beyond senior debt. Subordinated and mezzanine debt strategies are taking a greater share of investor dollars, and there is a concerted push into speciality finance areas – either asset-based or asset-backed – with real estate a growing area of interest.

According to Kipp deVeer, head of Ares Management’s Credit Group and CEO of Ares Capital, the operating conditions for the US private debt market are much better than the fundraising and deal data may suggest.

“New transactions are relatively easy to execute today: leverage is low, pricing is high, there is very lender-friendly documentation, and lenders have an ability to negotiate for favourable terms. The loans we are seeing now are about as good as I have seen in more than 20 years of doing this,” he says.

He argues that the backdrop for private credit remains beneficial in the US: “We feel the economy is still reasonably solid, and we are seeing growth in our portfolio and in most of the sectors where we are investing, which tend to be less cyclical and more defensive parts of the market.

“M&A activity is still slower than typical, but private credit’s share of new deals is much higher than in the past. Banks continue to be in a position where they are tightening credit, both because of what is going on in their businesses and the regulatory environment.”

Fundraising slowdown

The latest PDI fundraising data shows just 84 credit funds successfully raised globally in the first half of 2023, the lowest number since 2016, with a combined value of $84 billion, whereas $119 billion was raised in the first half of last year.

But institutional investors continue to appreciate the private credit opportunity, even with fundraising at record lows. Robert Molina, managing director and head of origination at placement agent Briarcliffe Credit Partners, says investors stand ready to increase their allocations to the asset class. “We have been plenty surprised that there are significant LPs out there, with meaningful amounts of capital, that are just building their private credit allocations now,” he says.


Raised from funds closing in H1, down from $119bn last year

Molina says there are still new allocators coming in who might have had minimal exposure to private debt or hedge funds but are now treating private credit as an asset class in its own right.

“We have started to see private credit allocations gain at the expense of infrastructure and real estate equity, because the expected returns of private credit have gone higher as interest rates have gone higher, and on a relative returns basis private credit looks more attractive,” he says.

Junior uptick

While direct lending strategies have delivered consistent returns, LPs are starting to look into more options within the private credit universe. Worldwide fundraising data shows subordinated and mezzanine debt strategies took a greater share of investor dollars in the first half of 2023 than ever before, accounting for 39 percent of all private debt fundraising.
Junior capital is just one area in which credit managers are seeing an uptick in demand.

Randy Schwimmer, co-head of senior lending at Churchill Asset Management, says: “In the US, for the first half of this year, we did roughly $5 billion of investment across our senior debt and junior capital platform, representing about 175 transactions. Those numbers relative to last year are ahead in the junior capital business by about 20 percent on last year, and on the senior side are on budget, which is good given the current environment.”

He says there are two reasons why sponsors are looking for junior debt. First, the LBO financing that is getting done today is for businesses in “good sectors”, where purchase price multiples have not come down that much, and yet the amount of leverage that can be put on those businesses given higher interest rates is much less. “The whole capital structure has gone in favour of lenders and made it difficult for private equity sponsors who need to put in more cash,” he says.

“Investors are looking to diversify into strategies like speciality finance areas that are either asset-based or asset-backed”

Robert Molina
Briarcliffe Credit Partners

Secondly, the fundraising for PE has also slowed, leaving sponsors asking for some junior capital to bridge that gap between the equity they need to put in and the senior debt.

Many lenders see speciality finance as a growing area of opportunity – particularly asset-based financing strategies outside of corporate credit. Says deVeer: “We are taking market share because of the pullback by the banks, both in corporate direct lending and in our alternative credit business on the asset-based financing side. We are seeing more opportunities where we are sourcing non-corporate investments that are tied to the assets.

“Alternative credit generally refers to illiquid credit, where we typically lend against a pool of assets generating contractual cashflows, whether that is royalties, lender finance, single family rentals, commercial or consumer credit receivables or similar. Most of that business was done by the banks years ago, but alternative providers like Ares are now filling that gap as the banks seek to exit certain non-core businesses.”

In June, Ares closed a deal to buy a $3.5 billion senior secured lender finance portfolio, including small business loans, asset manager and fund finance loans, and consumer and real estate loans from US regional bank PacWest Bancorp.

Relative strengths

For limited partners backing private credit, it is all pretty good news, according to Schwimmer. He says they are seeing senior debt unlevered returns of 12 percent, which contrasts sharply with the 7 percent that senior debt was earning 18 months ago. “Investors are encouraged by that,” he says.

“There is a question of not just relative value but also relative risk of private debt versus the public markets, so investors are re-engaging on questions such as default rates, liquidity and valuations, and they see the opportunity in private debt right now. The assumptions made in a zero interest rate environment look very different today.”

He says the story is not of a new opportunity in private credit, but rather of the markets highlighting what were always strengths of the asset class. “Yes, senior debt yields are as high as I have ever seen them, in combination with the most conservative structures. And yes, that has created the best vintage in 2022 and 2023 for a long time,” adds Schwimmer.

“But the private credit story hasn’t changed, it is just that all its benefits have been enhanced by the rate environment, and the illiquidity premium has increased. We think the Fed will fight inflation successfully, rates will come down, but overall LPs should still expect to earn a better yield in this asset class than in the liquid markets, and that yield will be more stable over time.”

Even against a backdrop of recessionary trends, with default rates tending to tick up from a very low base, US private credit markets look resilient, he argues.

“The loans we are seeing now are about as good as I have seen in more than 20 years of doing this”

Kipp deVeer
Ares Capital

“Just because default rates are going up does not mean that private debt investors should worry about the asset class as a whole,” says Schwimmer. “We have a pretty strong track record of minimal defaults and losses going back almost 18 years and we have found that the minute you have a financial covenant default, that is when you take the opportunity to sit down with the borrower and start fixing it.

“Then should you get to a payment default, it has been pretty well signalled and you have already set up a programme to get the company and debt restructured. What hurts performance is losses not defaults, so private debt investors can still feel pretty positive.

“The ability of these companies to access additional liquidity is critical and the beauty of private equity-backed companies is the sponsor also has the funds, with typically a 15 percent reserve, to contribute capital to manage through problems. The key in all these situations is giving the company time to heal.”

There are not significant signs of distress in portfolios today, according to deVeer. “We have our eyes on what could be a period of rising defaults across the market,” he says.

“Earlier this year, we did expect defaults to go up, but credit has been fairly benign, with defaults remaining below historical averages. Companies are performing quite well – they are adjusting to servicing debt with a base rate that has tracked up quickly, which has diverted more cashflow to pay interest to lenders.

“We are seeing a resilient yet slowing economy, and companies that have taken on a fair amount of debt are dealing with higher base rates. We don’t think that creates a significant level of stress, but we do expect defaults in most lending asset classes to go up a bit next year.”

Since deployment has been slower than expected in 2023 as a result of high inflation and rising rates driving a mismatch between buyer and seller expectations, deVeer now expects the next 12 to 18 months to be brighter. “I’m hopeful that because of the amount of dry powder, and the fact a lot of investors really do want to allocate to these asset classes, some rationalisation will happen. There is plenty of debt capital out there to support transactions, and I’m fairly optimistic for 2024,” he says.

Searching out new markets

In an asset class long dominated by direct lenders, senior debt is now a crowded field; diversification and the search for new markets have become the order of the day

Robert Molina at Briarcliffe Credit Partners says if you are a GP launching a private credit fund, your area of least competition is “really anything but direct lending”. “In direct lending there are many, many options for LPs – the areas of interest and of growth are in everything else,” he says.

LPs are keen on keeping their existing relationships with managers in direct lending because those returns have been pretty consistent, Molina says. “But they are not keen to do heavy work on underwriting new GP relationships there. Given that returns have been steady, they are happy with the strategy but they see no incentive to back more direct-lending GPs.”

Instead, diversification is the priority. “As they look to expand their allocations to private credit as a whole, investors are looking to diversify into strategies like speciality finance areas that are either asset-based or asset-backed,” he says.

Molina says enquiries about real estate debt are increasing, partially because they are deals with identifiable assets but also because there is some expectation there will be a maturity wall in real estate debt not solved by traditional lenders, “presenting real estate credit with an opportunity”.