‘Large-cap direct lending is only becoming more important’

We take the temperature of the market based on conversations with some of the asset class’s biggest fundraisers.

Did someone say covid? With private debt’s top 50 fundraisers surpassing $1 trillion in capital over a five-year period, our ninth survey of the market’s top fundraisers demonstrates that the asset class has kept motoring through the pandemic.

“We don’t have a crystal ball, but there’s real momentum in the direct lending market,” says Mitchell Goldstein, partner and co-head of Ares Credit Group, whose parent Ares Management captured the top spot in our ranking for the third year in a row.

In the past five years, Ares has raised an eye-popping $81.3 billion, and has shot out the lights in fundraising this year. In the first nine months, the Los Angeles-based firm raised substantially more capital than it did in all of 2020. “We believe that there is still significant opportunity for further expansion of the direct lending market, and we don’t expect to see a material slowdown for the foreseeable future,” Goldstein says.

Michael Smith, co-head of Ares Credit Group, believes that the US direct lending market has already reached $1.5 trillion, a far cry from the $300 billion or $400 billion market that existed 10 years ago. “There has been a general acceptance of the asset class and greater sophistication from the providers,” Smith says, while the size of deals and the market opportunity continue to grow. “We look to use our size and scale to finance bigger companies through the evolution of their growth.”

James Vanek, partner and co-head of global performing credit at Apollo Global Management, which this year moved up to eighth from 11th place last year, says: “The trend toward large-cap direct lending is only going to become more important as clients look for solutions to generate returns in a highly thoughtful and structured manner.”

Apollo’s size and investment in front-end origination positions it as one of a handful of lenders that can finance an entire deal.

“With large direct loans, we’re taking more share from the broadly syndicated market where banks aren’t underwriting risk like they used to,” Vanek says. “We can offer good companies a low cost of capital and we can be more flexible than the CLO market.”

Although the banks are outsourcing origination, they are still accessing the private debt market by lending to the big players, according to Ares’ Goldstein. “Banks are very large investors in this market,” he says, adding that “we believe that it is much more efficient and easier for them to lend to investment-grade entities such as Ares Capital (the business development company)”, than to originate the loans themselves.

Pile of capital

At the same time, private equity managers, the primary users of private debt, are sitting on a tremendous amount of capital waiting to be deployed.

“What is most extraordinary about 2021 is that it has been far and away the most active year for private equity, and by extension, private credit,” says Dwight Scott, global head of Blackstone Credit, which moved up a notch this year to take third place. He sees activity seamlessly continuing into next year, driven by mergers and acquisitions, along with the attractiveness of private credit’s defensive and floating-rate nature.

The pipeline of transaction opportunities for private debt managers is “promising”, given that the ratio of dry powder held by private equity firms – the primary users of private debt capital – to private debt funds is 5:1, notes Armen Panossian, head of performing credit and portfolio manager at Oaktree Capital Management, citing data from law firm White & Case. Oaktree this year continued its steady climb in our rankings, moving up to fifth from eighth place last year.

“We don’t have a crystal ball, but there’s real momentum in the direct lending market”

Mitchell Goldstein
Ares Credit Group

Moreover, the appetite among investors for private debt remains strong. “We’re seeing LPs rotate portfolios from liquid credit to private credit in their hunt for yield,” says Panossian. He notes that private debt funds have produced attractive current average yields of approximately 7 percent, versus average yields of 4.73 percent for high-yield bonds and 4.61 percent for leveraged loans.

The managers we canvassed generally agree that leverage has risen only slightly from its pre-pandemic level, and they observe that the strong economy and cost-cutting during covid is mitigating risks. “The fundamental environment remains strong for certain sectors,” says Apollo’s Vanek, adding, “and in this environment we generally expect continued outperformance”.

“Generally, the economic environment is relatively supportive of most of the investments in our portfolio,” says Scott of Blackstone. “They’re not especially levered and earnings are increasing, which is quite supportive of debt.”

Furthermore, cash equity to support most new mid-market leveraged buyouts “remains quite substantial”, says Oaktree’s Panossian, noting that 50 percent or more of the average purchase price is funded by the private equity sponsor.

Concern about Ts and Cs

“We have to be very mindful about terms and conditions,” says Dan Pietrzak, partner and co-head of private credit at KKR. Although he believes the overall market is “frothy”, and that terms got “a little worse” post-covid, KKR has been proactively positioning its portfolio by “materially enhancing” its platform over the past five years, building out its origination footprint and “institutionalising its platform” in terms of process. The manager remained in the top 20 but slipped a few notches from last year to number 17.

In the private debt market, “there is no run on the bank scenario”, Pietrzak says, adding that “the structure of capital has been pretty thoughtful”. Among other concerns held by the top managers are inflation and the debate over raising the debt ceiling.

Given that many of the largest managers are publicly traded, they answer concerns about transparency by pointing out that they are subject to regulatory oversight. Blackstone’s Scott notes that BDCs provide publicly available financial information about their portfolio every quarter. For instance, the firm’s data science team can update holdings and marks across all BDCs each quarter, which is not possible to do with bank portfolios.

Although the awareness of environmental, social and governance goals has been growing, many top managers have long considered ESG criteria in decision-making. Private lenders generally screen potential borrowers on ESG measures during due diligence. Because they don’t operate businesses, they haven’t had as much influence on their portfolio companies as private equity sponsors. But that is changing, with some like Ares using ESG performance goals in its documentation process and revamping its hiring to include direct recruitment on campus. While most funds have a firmwide head of ESG, Apollo recently hired its first head of ESG credit. And KKR is on track to triple its ESG group by year end.

Other trends to watch as we enter the new year: the increased focus on the retail market by the big private debt managers, many of whom already address that market through their BDCs. Blackstone launched its Private Wealth Solutions business targeting individual investors a decade ago, and as of 30 September 2021, individual investors represented around 20 percent of the firm’s AUM.

In the fall, Ares created a 90-person private wealth solutions business, and KKR has doubled the size of its global team in the past year and announced some high-profile hires in the area. Also of note: the continued focus on large-cap lending, as well as asset-based finance and lending to complex, or “unloved” sectors such as travel and leisure.

Just how long the good times will keep rolling is anybody’s guess, although the top managers generally agree that fundraising will remain robust and private credit will continue to take market share. “Before covid, I used to say we were in the 10th or 11th inning,” says KKR’s Pietrzak. “All of a sudden the game ended and a new one began.”