Direct Lending Investments
For many institutional investors, private debt is still something of a new departure: the vast majority of bfinance clients that are currently active in the asset class have entered it within the last decade. Today, investors are seeking to clarify the long-term role of private debt and direct lending within portfolios, refining expectations for yields, risks and returns going forwards. Strategy and manager selection are crucial, with many seeking returns that defy the yield compression of the last five years.
Direct Lending Funds
The private debt universe is highly heterogeneous, with a broad range of strategies and a risk/return spectrum at least as wide as listed bonds. While corporate direct lending still represents the largest sub-sector, there is an increasingly broad, diverse universe of investable strategies across infrastructure debt, real estate debt and corporate debt. Some of these segments, such as direct lending-type infrastructure debt strategies, were barely in existence as credible opportunities for our clients three years ago.
The chart, although simplified, illustrates the spectrum of private debt investment types according to potential (gross) returns and risk. Direct Lending still, in general, commands slightly higher yields than real estate debt of equivalent seniority, and notably higher yields than infrastructure debt. Yet these sectors have very different risk profiles, with much “real asset” debt essentially backed by assets (property, infrastructure) while direct lending is backed by corporate cashflows.
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The private debt universe has undergone considerable change over the last decade. Private debt in general, and direct lending in particular, have become part of mainstream asset allocation for many pension funds and other asset owners seeking income in an era of low yield. A high volume of new entrants to the asset class was highlighted by the previous bfinance Asset Owner Survey. Many of these newer entrants were initially drawn towards private debt by the indisputably compelling post-GFC opportunity presented by senior corporate direct lending after banks pulled back from the space – an opportunity that contrasted starkly with the yields available on low-risk bonds in a low-rate climate. With both diversification from equities and healthy yields on offer for a relatively conservative risk profile, the decision to enter private debt was – for many – a no-brainer. Fundraising surged in 2013 and peaked in 2017, with nearly $250 billion of new capital flowing into private debt funds globally that year. We do still note new investors entering the sector, particularly among certain groups of insurers and Defined Contribution schemes for whom illiquid investment may previously have been problematic.
This investor demand has driven higher deal volumes and a rising volume of dry powder. Rising popularity and higher investment volumes have contributed to declining spreads, particularly in mid-market sponsored corporate lending. This has undoubtedly contributed to a recent slowdown in capital raising for this asset class. According to Private Debt Investor, overall Private Debt fundraising in 2019 dropped to $147 billion, down from $166 billion in 2018. This decline was primarily attributed to corporate debt (where new fundraising dropped by 17%). Infrastructure debt fundraising, on the other hand, rose from $9 billion in 2018 to $14 billion in 2019 – the second highest figure recorded, exceeded only in 2015. Real estate debt fundraising dipped only slightly (from $29 billion to $27 billion), following an exceptionally strong fundraising wave in 2013-17 (average $35 billion per year). We have seen a wave of fundraising for distressed credit and credit opportunities from 2017 onwards, despite the considerably longer lock-ups and lack of income distribution, but investors have been grappling with timing – a number of funds have been returning money to investors when sufficient “distress” failed to materialise.
Direct Lending Fund Selection
At bfinance, clients seeking new Direct Lending managers during the last twelve months have brought very different portfolio structures and priorities. Investors’ approaches to this asset class are varied. Much corporate direct lending tends to be treated as an alternative to conventional fixed income, while funds at the distressed end of the spectrum may well sit within a private equity-type allocation. Real estate or infrastructure debt can form part of a diversified “private debt” allocation or may sit as part of a “real asset” portfolio alongside real estate and infrastructure equity investments. On the whole, European and Asian investors continue to show a lower tolerance for risk and leverage than their North American peers. Around the world, many investors are hoping to obtain returns that defy the yield compression of the last five years, searching for more profitable niches where the supply/demand dynamics are less overcrowded.
At bfinance, we believe it is essential to take a highly tailored approach to portfolio design and manager selection, based on the needs of the specific client, and avoid ‘buy lists.’ This is especially true in private debt and direct lending, where the number and variety of funds available has rocketed during the last decade. With high fund performance dispersion relative to fixed income, due to the concentration of portfolios in a relatively small number of loans, manager selection is critical to success; this dispersion is likely to be even higher in the event of stressed scenarios. To recycle Warren Buffett’s analogy, all are hoping that their selected partners are wearing trunks before the tide goes out. Yet few managers have really had their loan restructuring capabilities, credit watch processes or other aspects of risk management tested in recent years, creating a manager analysis challenge.