Why it might be time to stem the direct lending flow

We are entering the 10th year of boom times and credit markets have reached a tipping point, at least as far as Leon Black is concerned.

“The credit markets, unlike equity markets, have gone to bubble status,” the Apollo Global Management founder, chairman and chief executive said in December at the Goldman Sachs Financial Services Conference, per multiple news reports.

Yet none of this has inclined limited partners to turn off the direct lending tap, according to Perspectives, our annual limited partner survey. Some 37.7 percent of investors polled plan to increase their allocation to it this year, which beat all other strategies including special situations, venture debt and collateralised loan obligations.

Indeed, the Arizona State Retirement System has bumped up its allocation to private debt to a target of 20 percent of its portfolio, with much of it going toward US corporate direct lending.

Certainly, some pension funds are trimming their credit allocation, like the Louisiana School Employees’ Retirement System, which is trimming its opportunistic credit allocation from 15 percent to 13 percent, but more appear poised to follow Arizona’s lead.

Ares Management’s prodigious fundraises are evidence that the strategy has attracted, and will keep attracting, large amounts of capital. At the end of 2017, it raised $3.4 billion for its first junior debt private fund. In July, it collected $7.5 billion for European direct lending, and in the opening days of 2019, the firm closed on a $3 billion vehicle for US direct lending.

One popular mantra among private credit managers is that there is too much capital chasing too few deals – some 63 percent of investors said that is a factor keeping them up at night, according to a new Probitas Partners survey.

Those investors that participated in our survey did express reservations over the deal market. Some 66.3 percent of LPs, which ran the gamut from pension funds to sovereign wealth funds, cited extreme market valuations as a chief concern. Rising interest rates took second place, with 56.1 percent of investors expressing reservations about increased borrowing costs.

All that dry powder isn’t necessarily a bad thing. Per Probitas’s findings, there is almost $1 trillion of private equity dry powder in North America alone. That untapped capital is going to have to go somewhere, and someone will have to finance those deals. Who better than direct lenders to step in and execute the deal quickly?

But some would say that too much capital is one of the factors causing the deterioration in direct lending deals and contributing to overheating credit markets.

So, is it time to quit direct lending?

Oaktree Capital Management co-chairman Howard Marks tackled the question in his latest memo.

“Nothing in the investment world is a good idea or a bad idea per se,” he wrote. “It all depends on when it’s being done, and at what price and terms, and whether the person doing it has enough skill to take advantage of the mistakes of others, or so little skill that he or she is the one committing the mistakes.”

The takeaway – and perhaps guiding principle for the year – is investors beware, and pick your managers carefully.

Write to the author at andrew.h@peimedia.com.