Filling a bank-shaped hole

as private direct lending grows across the world, investors – particularly institutional investors – are being drawn to its promise of attractive returns with features that can be like a cross between fixed income and private equity.

However, recently some investors say the returns and conditions they seek have become elusive. One pension fund representative noted that he came up empty- handed after scouting extensively for private direct-lending opportunities that met his goals.

At Ascension Investment Management, which manages assets for a Catholic health- care system as well as outside investors, Michael LeVar, director of income strategies, followed the direct-lending trail to Europe, where opportunities were supposed to be more abundant as a result of the retreat from business lending by banks facing more stringent regulation following the financial crisis. But after several trips to Europe, he returned home scoreless.

LeVar says he anticipated earning a premium in Europe for the extra work and difficulty of deploying his capital, including the need to hedge currency and the uncertainty of creditor rights from country to country. Europe was not willing to pay up. “The premium I was hoping for really wasn’t there,” LeVar says.

What he and the pension fund official discovered, say some experts in the field, is a gradual decline from expected returns for direct-lending investments as more play- ers crowd in. Returns at or near double digits that were attainable a few years ago in certain types of direct-loan programmes have fallen to as low as the 6-7 percent range today for the most secure loans – not enough to justify the reduced liquidity to many institutional investors.

But apparently there are still more than enough institutional investors eager to play the direct-lending game at current levels to fuel continued growth.The New Hampshire Retirement System and the School Employees’ Retirement System of Ohio each recently committed more than $50 million to the BlueBay Direct Lending Fund II, according to PDI Research & Analytics.The City of Fresno Retirement Systems also committed $50 million to the Crescent Direct Lending Levered Fund.

NEW PLAYERS

The two dedicated direct-lending funds are among many run by established private lending and credit specialists.Those players are now being joined by newcomers raising money for their own direct-lending efforts. These newer players range from firms like Direct Lending Investments, which runs a fund that buys small business loans from online lenders, to hedge funds looking to expand into direct lending.

Gapstow Capital Partners, a credit- focused hedge fund of funds, recently switched its attention from distressed credit and debt to private direct lending.

“The world is much more about new credit creation now, and that is where we are finding the most interesting oppor- tunities,” says Christopher Acito, chief executive and chief investment officer at Gapstow. “Private credit and direct lending is the highest priority for us in our research initiative.”

Gapstow says there is no shortage of hedge fund managers who until recently specialised in trading legacy credit instru- ments but are now moving into some form of direct lending.“A lot of hedge fund managers active in credit, particularly structured credit, have become interested in direct loans,”Acito says. “They are finding it is the next interesting extension of their business.”

Neil Sheth, head of alternatives research at NEPC, an investment consultant that also allocates on behalf of institutional clients, says there is so much capital raising for direct-lending funds taking place that the competition for lending deals may make it more difficult to produce returns that satisfy investors.

“People are raising money in certain seg- ments with lots of competition,” Sheth says. “They will have to put it to work whether or not there are attractive risks and returns.” That doesn’t mean Sheth is ready to toss in the towel. Opportunities remain in direct lending, he says, for managers skilled at sourcing and underwriting loans. While LeVar did not see much that wowed him about direct lending in Europe, Sheth remains convinced that there are more
opportunities abroad than in the US.

One thing is clear: private direct lend- ing has become the favourite flavour for investors looking to allocate to private debt. Over $16 billion was raised for direct lending in the third quarter, representing 56 percent of all capital placed with credit funds closed during the period, according to PDI Research & Analytics. Of the $90.7 billion raised for debt strategies in the nine months to 30 September, direct lending made up just over 50 percent of the total. Whether all that money and all those managers will combine to create a “frothy” environment where return expecta- tions cannot be met remains to be seen. Eric Lloyd, head of global private finance at Babson Capital Management, a global investment firm with a private debt specialty, says that the expansion of funds and managers in direct lending is being matched by more demand on the part of borrowers for private loans. “Has competition increased in this asset class? Absolutely,” Lloyd says. “Has the supply of opportunity increased? I think it has.”

DISAPPEARING BANKS

What’s driving the trend is the diminished role played by banks in debt financing, particularly in Europe, where they once accounted for about 80 percent of lending. The financial crisis prompted tighter bank-lending guidelines and a hasty retreat from direct lending that left businesses and real estate operations starved for financing as the global economy recovered.

In a recent research paper, direct-lending specialist White Oak Global Advisors cited a study indicating that 50 percent of would- be business borrowers are now rejected by banks. Many of those borrowers are still considered good credit risks, but simply fall a notch or two below the requirements banks now follow.

As more businesses began looking for private loans, more investment firms began raising money to meet the demand.

DEBT PERFORMANCE

White Oak noted that from 2009 to 2014, about 150 new private direct lenders entered the space.

One of the problems in trying to reach broad conclusions about the direct-lend- ing market is that it includes so many different varieties.There are term loans and asset-backed loans, senior and mezzanine debt, small business loans and real estate development loans.

But despite that diversity of opportunity, most of the money gets deployed in a much narrower range. According to White Oak, 80-90 percent of private direct lenders focus on business-term loans, and within that category, more than 80 percent of the loans go to companies that have a private equity sponsor. Other sources indicate that mid-market companies – typically companies with $500 million-$2 billion in revenues – get the largest share of this form of financing.

But even within the mid-market direct lending space, opportunities and returns can vary widely, based on the size and type of businesses being targeted, the duration of loans, and the leverage used by the fund. Investors looking to maximise returns now must be willing to give up loan quality in exchange for higher returns, and thus may put themselves at risk of high default levels that eat up expected gains.

Sheth points out that investors in pri- vate lending funds need to pay special attention to liquidity and to the lag time between when money is committed and when it is actually deployed.A direct-lend- ing fund that aims for a 10 percent rate of return might sound good, but if it takes years to deploy the committed capital, the total return on committed capital will be far less even if the deployed capital earns that 10 percent.

In short, getting an 8-10 percent return on direct lending today is much tougher than it used to be. As LeVar points out, investors shopping for deals need to weigh the level of risk they are willing to accept – particularly the quality of the business and the terms of the loan.

“Some of the direct lending two or three years ago that was paying 14 percent is now at 9-10 percent,” LeVar says. “You have to wipe the history of pricing clean and look at investing today.You have to ask yourself, would I invest in this company at 9-10 per- cent? I have seen more of the safer stuff going at 6-7 percent.”

FINDING THE RIGHT LABEL

For investors looking to participate, a key issue remains how to categorise direct lending – and thus what level of return is appropriate. Some investors look at direct lending as a derivative of private equity: both involve investments in private companies and both have long holding periods for which investors expect to earn an illiquidity premium for committing their money for years.

But because private lending is debt rather than equity, some investors look at it as an investment that can be substituted for fixed income, which typically has a much lower return profile than private equity.

Sheth says the best way to think of private direct lending is as an opportunistic play and to allocate accordingly.That means monitoring the various niches within direct lending like mid-market companies or regions like Europe, the US and Asia, and trying to spot fleeting opportunities.

“We think you should allocate your capital to this category only when the opportunities are attractive,” Sheth says.

So what is an attractive rate of return for direct lending these days? To Acito, at least, it is a question that must be answered in the context of the times. “Isn’t even a net 6 or 7 percent return from these strategies pretty good these days?” Acito asks.