Performing credit investors getting lower returns – Oaktree’s Marks

Direct lending fund managers have enjoyed record-breaking fundraising since last year, reflecting a strong demand for direct lending fund investment from institutional investors.

But despite the robust year that fundraisers have experienced, Oaktree Capital Management’s co-founder and co-chairman Howard Marks told PDI at a roundtable discussion hosted by the firm’s Hong Kong office that the return profile of performing credit strategies is likely deteriorating as he predicts that global economic growth will soften during 2019-2021.

According to Private Debt Intelligence published on 15 October by The Lead Left, a publication for mid-market debt  trends, 31 private debt funds held a final closing and secured a total of $24 billion in capital during the third quarter, including an aggregate of $19 billion raised for 15 closed-end direct lending funds in Q3 2018.

The average direct lending fund size is now $1.3 billion, which is the largest average size for a direct lending fund of any quarter in the last five years.

Most recently, PDI reported that BlackStone’s credit platform, GSO Capital Partners, raised a total of $10.8 billion in the third quarter this year, including $2.6 billion for its new direct lending platform.

European managers including Alcentra and EQT Partners are also raising billions for their direct lending strategies. For instance, Alcentra European Direct Lending Fund III has garnered over $2.7 billion this year, while EQT Mid-Market Credit II is now sized at over $1.75 billion, according to PDI data.

Speaking to Oaktree Capital co-founder Marks about his view on whether investors to the direct lending strategy will be compensated enough, he said: “It is all a matter of skills – the ability of the lender, in this case, the loan portfolio manager to judge credit quality and demand an adequate return. – It is hard sometimes to demand an adequate return in a hot market.”

He added: “When there is too much money and too few deals and the bidding is hot, the result is not always, but often, that the price is too high, the yield is too low, and the risk is too high and [you have] a weak [loan] structure.”

An investment officer at a Korean institution agrees with Marks’s view that the return profile of loans to creditworthy companies in the US is now too low to bear.

He told PDI today that the return profile of  US direct lending is not attractive to his organisation now as he sees more competition, higher leverage, and fewer covenants across direct corporate lending transactions.

He added that even for the US mid-market direct lending strategy, where a better return rate is available to investors, business development companies are the dominant force in direct lending to US corporates.

“We see unlevered expected returns of five percent from US direct lending funds whereas the European funds are offering seven to eight percent [IRR] on an unlevered basis,” the investor source noted, adding that his team has committed an undisclosed amount of capital to an offshore direct lending fund this year. PDI understands that the institution has further exposure to direct lending strategies both in the US and Europe.