Direct Lending: The second generation

“Our market has really only taken off in the past three years.”

So says Blair Jacobson, a London-based partner in Ares’ direct lending group. Ares has been in the game for seven years, but Jacobson quickly acknowledges that the acceleration of this segment of private debt is more recent.

Fifteen successor direct lending funds reached a final close in 2015, of which 10 were second or third fund iterations. Of the 27 non-debut direct lending funds in the market, 21 are second or third funds. Direct lending is maturing and, as with any strategy, the market evolves as it develops.

The substantial growth in direct lending in Europe and the US divides commentators and there is little consensus on what is in store for the second generation of direct lending funds.

Some view it as inevitable given the increased regulatory burdens hitting the banking industry globally. Others point to almost 10 years of historically low interest rates and the bubbles and contrary investment behaviour that it has inspired to remind direct lending boosters that illiquid assets are never an investor’s first pick.

Whoever is right – and its PDI’s view that both arguments are valid with the eventual market path falling between the future promised by each – the managers who got their skates on early have two funds under their belt and are onto at least their third fund. Managers on funds beyond III are truly veterans and a clear minority. But the number of new managers inevitably means that the market has changed since anyone first hit the road banging the drum for their private debt fund.

“From a macro perspective that affects everybody, you have one good thing going in that people increasingly accept private debt as an asset class and as something that they are already doing or should be doing,” says Neuberger Berman’s head of private debt, Susan Kasser.

“On the other hand, you do have more people making the very valid observation that if there are this many conferences dedicated to this asset class, is the opportunity not as attractive as it used to be.”

So while direct lenders are happy that investors now understand and like what they do, they also very frequently have to answer questions about whether that proliferation of managers is something to worry about.

“We think there’s a pretty good balance between the growth in the market and the capital that is being raised by alternative lenders,” says Jacobson, adding that in Europe in particular, the need for capital has been acute and with even fewer choices of lender for corporates than the US.

KKR’s Erik Falk says that the private equity firm got into direct lending because of the weight of demand from borrowers. It had done several deals using capital from pools not focused on the strategy before deciding to raise its first fund in 2011. The lender closed its second direct lending fund on $1.34 billion in April last year and has built up assets in its BDC to reach $4 billion. In the US, debt funds competitors include banks, BDCs, family offices and mid-market CLOs. This doesn’t deter Kasser who closed Neuberger’s first fund on $620 million in September.

“Just because a market is competitive – and the US market has been competitive for as long as I’ve been doing it, which is almost 15 years – doesn’t mean it’s efficient. So if you can find enough deal flow, you should be able to find enough investments.”

Kasser declines to talk about fundraising but deployment of the first fund was far enough along when the $620 million vehicle closed last September for Neuberger to get straight back out on the road, as PDI reported at the time.

In support of his point that the deal market is expanding in line with the capital raised, Jacobson highlights that Ares is not in a perpetual merry-go-round of credit calls with peers.

“What’s interesting is that we rarely bump up against the same competitors in a given deal – it’s shockingly inconsistent. If and when we lose a deal, it tends to be to a bank club rather than one of our peers,” he says.

DIVERGING PATHS

Many investors are keen to take advantage, but are equally still wondering where this relatively untested end of the credit market will end up. And more importantly, which horses to back. Ares’ Mike Dennis, also a London-based partner in the direct lending group, says that anyone really most concerned about an overcrowded market should look at where the concentration of managers is densest.

“You’ve got to look at where the capital inf lows have ended up vis-à-vis the new direct lenders. There is a counterintuitive dynamic in the market where if you’re trying to raise €20 million-€50 million of debt capital, then there is more liquidity for those deals than for deals requiring €50 million-€250 million of capital. And all this liquidity is driving leverage and pricing that is not really appropriate for the risk you’re taking for those smaller companies,” he says.

Ares has worked hard to increase its capital to gain altitude above the crowded end of the mid-market. The firm is raising its third European direct lending fund, passing the €2 billion target before the end of 2015 and with the €2.5 billion hard-cap in sight, PDI reported in December.

Of course, judging the real risk sitting on private debt managers’ balance sheet is difficult.

“I don’t think we are going to get a report card in 2016 on the new funds that have recently entered the direct lending market, especially considering that there is so much competition for the smaller deals where history shows that there is more inherent risk,” adds Dennis.

RISK CALCULATION 

Back in the US, the Federal Reserve’s moves last year that prompted bank lenders to pay more attention to the regulators’ leveraged lending guidelines saw net debt to EBITDA multiples on deals fall on average. Direct lenders are not ruled by those guidelines, though, so should investors concerned about the true risks ask managers to abide by them? 

“The reason for regulation is more about systemic risk and shareholder deposits and the ability to meet those deposits and transact fluently,” says Falk.

“I don’t think the depositors of the bank have a clear understanding of what risks the bank is taking and I would argue that not all shareholders and other constituents understand. So the question of regulating banks, similar to regulating insurance companies, is about having a mechanism for ensuring financial strength so they can meet repayments for people who shouldn’t be expected to evaluate all the details behind the balance sheet,” he says.

Falk adds that KKR’s investors are sophisticated enough to understand the risk-reward dynamic and have the reassurance that KKR’s own interests are aligned with them via the managers’ own capital commitment to the fund.

The risk question complicates things for investors now evaluating a continually expanding array of managers, few of whom have a long track record. A difficulty Kasser acknowledges: “Nobody in this industry is buying an index of private debt, you are selecting a manager who you think can source better, filter better, execute better than the market statistics.”

The strength of any manager, then, always lies in the assets that they gather on behalf of investors, and the selection process must concentrate on getting a true understanding of the risks in a manager’s portfolio.

But that takes a real understanding of both credit and how businesses work. Which means nervous investors must ask themselves: you may be convinced by the returns, but how much do you really understand debt?


CASE STUDY: COMING CONSOLIDATION

Last year, the next generation of direct lenders began to grapple with one inevitable side effect of market evolution – consolidation. General Electric’s announcement last April that it would sell most of its GE Capital units could be seen as the start of a wave of M&A among non-bank lenders.

GAM/Renshaw Bay, Fortress/Mount Kellett, PennantPark/MCG, Omni Capital/Brookland and Hayfin’s internal shareholder reorganisation all went through in 2015.

There were also some high-profile failed deals. Ares and Kayne Anderson dropped their planned merger, while Apollo pulled out of buying all but a small slice of AR Capital.
KKR’s Falk says that financial institution M&A is always particularly complicated with a percentage of deal inevitably not crossing the lines. He adds that the major source of consolidation over the coming years will be the accumulation of assets by individual managers. In other words, the big fish will just get bigger.