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Hotting up

10 Dec 2018

Has the direct lending market become a victim of its own success? Mark Dunne investigates.

Direct lending is losing its shine. Institutional investors have become a prominent fixture in the asset class through supplying loans totalling hundreds of billions of dollars to mid-tier corporates. For years the arrangement worked well with the loans returning steady income streams well above the coupons offered by high-grade publically-tradable bonds. How times have changed.

With record levels of capital flowing into the asset class yields are falling and some non-bank lenders are taking greater risks to fight off the competition to close deals. In some cases this has included lower convents in loan agreements and even lending at ratios that exceed regulators’ recommendations. In short, the increasing popularity of this alternative asset class is seeing institutions take more risks for lower returns.

This alternative debt universe is diverse. The market, which is also known as private debt or private credit, comprises mezzanine capital, loans secured against real estate and infrastructure, distressed debt, special situations, bridge financing and direct lending, where the middleman, being the bank, is removed from the lending process.

These asset classes are used by institutions to generate higher returns than those offered by traditional fixed income assets, to diversify portfolios or to de-risk by switching out of higher risk assets such as equities.

It is a popular strategy. In July, Ares Management raised €6.5bn (£5.7bn) for its fourth European direct lending fund in what is the largest fundraising this market has seen.

The US alternative assets manager received €2bn (£1.7bn) more than it intended for Ares Capital Europe IV having initially targeted €4.5bn (£3.9bn). This was well ahead of its previous direct lending fund, which secured €2.5bn (£2.1bn) of commitments in 2016. With leverage, the fund could have up to €10bn (£8.7bn) of firepower.

So managers are not having too much trouble raising new capital for direct lending funds. Ares’ latest fundraising followed a strong 2017 in terms of capital flows into the asset class. Direct lending funds globally secured $52.6bn (£40.5bn) of commitments in 2017, according to data provider PitchBook’s calculations. This was close to half of the record $118.7bn (£91.5bn) invested in all private debt funds during the year.

“The market is getting bigger,” says Scott Robertson, Phoenix’s head of financial management. “There is a lot more debt in the world than there was 10-years ago.” The private debt market recorded a compound annual growth rate (CAGR) of 20.5% between 2009 and 2017, which is more than twice the 8.1% recorded by private equity buy-out funds.

It is little wonder that Pictet Asset Management describes the private debt market as “too big to ignore”.

SUPPLY-DEMAND MISMATCH

Large pension funds, insurers and sovereign wealth funds are behind many of the more than 80 direct lending firms in Europe, according to researcher Preqin. This is a sign of how the market has grown since the financial crisis when only three such firms were lending directly in 2008.

“It shows the appetite for anything that can give a return,” says Stuart Trow, a credit strategist at the European Bank for Reconstruction and Development (EBRD).

Indeed, direct lending funds have returned around 20% in the past year, according to Preqin, and by an average of 13% over the past five years.

Direct loans are typically unsecured, but even when the debt is secured against an asset, juicy returns of between 7% and 9% are on offer, according to consultancy Lane Clark & Peacock. “You can see why people are doing it,” Trow says.

Phoenix, a consolidator of closed-life funds, has a £24bn fixed income portfolio. Around £2.5bn of this is private debt, which is directly sourced by a team of six.

The group looks for assets that are a good investment-grade risk with predictable cash-flows, are resilient to changes in economic cycles and generate a steady stream of income.

“Phoenix has been around for centuries and will be around for a few more to come,” Robertson says. “So I am not looking for private equity-type returns. I am looking for stable, predictable cash-flows.”

These standards are one of the reasons why Phoenix only agrees half of the deals it finds. Those that made the cut include lending £75m to Yorkshire Water and £50m to Anglian Water. Birmingham City Council borrowed £45m from the insurer. The council passed selection due to a credit rating that is similar to that of a sovereign and is a long-term deal that does not mature for more than 20 years. Robertson would not disclose how much the group is making from the deal.

DRIVERS OF DEMAND

The stimulus policies that central banks introduced following the financial crisis have driven the prices of bonds up, which have sent yields down.

Those having the stomach for more risk are looking for better returns than those offered by investment-grade corporate bonds and government debt.

Dodging equity market volatility is also on their agenda.

Another benefit of going private with a fixed income portfolio is that there is a greater depth of companies to back. “Generally, markets are becoming more private,” Robertson says. “Not just in bonds, but equities too.” He adds that there are fewer companies wanting to list, a nod to an increasing amount of capital looking for private companies to back.

This interest in private businesses is likely to increase from those with private debt strategies. Indeed, more than half (51%) of global investors surveyed by Preqin in December have a positive perception of private debt. Only 12% of respondents held a negative view of the asset class.

A BORROWER’S MARKET

This bullish view has created a problem for investors. The asset class’ popularity since the financial crisis has led to a supply and demand imbalance.

Indeed, direct lending funds had $236bn (£181.9bn) of dry power at the end of 2017, according to Pictet Asset Management. This compares to the $667bn (£514bn) of assets the direct lending industry has under management, so competition to put capital to work here is increasing.

“You have a lot of money chasing fewer and fewer compelling opportunities,” says Supriya Menon, senior multi-asset strategist at Pictet. High levels of dry powder mixed with increased competition amongst institutional lenders have seen “spreads tighten significantly”, she adds.

A benefit of cutting out the middleman is that lenders have more control over the terms of a deal than if they issued a listed corporate bond. However, as more players enter the market lenders are losing some of their influence.

This has led to a rise in loan agreements having fewer conditions on collateral, payment terms and levels of income attached, being dubbed covenant lite, “cov-lite” in industry jargon. Of loan issuance globally, 58% is cov-lite, according to Pictet, up from 30% in 2013. So more and more investors have less protection against future default cycles. Borrowers are the beneficiaries of such competition; the losers are the lenders, who are taking more risk for less reward. “The balance of power has moved against the creditor in favour of the debtor,” Menon says.

“Weaker covenants enable companies to issue more debt than would normally be the case and that reduces their ability to re-pay [the loan],” she adds. “This points to lower recovery rates in a future default cycle.”

Menon warns investors to be more cautious with this asset class. “There are good reasons for investing in it, it has had a good run, but the investment case is less compelling now. Valuations have moved against the investor.”

Low standards of investor protection are a concern. They are, after all, lending to companies that the regulator considers to be too risky for banks to lend to unless they hold more cash in reserve.

So could this put savers’ retirement funds at risk? “The only thing that makes me comfortable about it is that private lending is a small part of the global debt market and that the real money going into it is not highly leveraged,” Trow says, pointing out that direct lending funds in the US are limited to only borrowing as much as they raise in their funding rounds.

“In terms of being a systemic risk, we are not talking about the same sort of thing as the financial crisis, sub-prime and all the rest of it,” he adds.

It is not just having fewer restrictions in loan agreements that are increasing the risk for investors. Some managers are reported to be stretching the definition of a company’s earnings beyond the six times earnings before interest, tax, depreciation and amortisation (EBITDA) ratio to increase the amount of cash that they can lend a company. “It amounts to the same thing, a weakening of protections for investors,” Trow says.

Yet on the other side of the coin, too much influence over the terms of a deal could be a problem. “The risk with private debt is that you are creating your own model, setting the terms of the deal, doing your own valuations,” Robertson says. “It is always good to have a third-party to independently review the credit and investment case for these private assets.” Phoenix uses Aberdeen Standard, its asset manager, for this task.

PHOENIX FROM THE FLAMES

Institutional interest in removing the middleman from the lending market accelerated after the financial crisis, when banks pulled-out of several markets.

It is not just commercial pressures that have seen banks retrench from lending to smaller businesses, there are regulatory constraints too. A drive for stronger balance sheets by regulators means that banks are mainly focusing on lower risk and, therefore, lower yielding deals.

This has led many banks to decide to focus on larger companies, while crowd-funding and fintech platforms have arrived to meet the needs of micro companies. This has led to a gap for small and medium-sized companies needing debt financing, who can find it expensive to raise cash from the bond markets.

It makes sense for pension schemes to enter the private debt market to align their long-term pools of capital with the longterm needs of some companies.

One issue with bank lending is that there can sometimes be liability miss-matches. That is not the case with pension funds where there can be a better alignment of capital. This is unlikely to cause a credit crunch as high number of defaults would have less impact on the economy, although it has repercussion for the schemes in question. “It is more of a slow burn, a slower removal of credit from the economy,” Menon adds. “This is probably positive because it is less of a shock.”

This theory is largely untested as the sector has not experienced economic turbulence since it started growing from three funds in 2008 to more than 80 today. Indeed, the average default rate in the direct lending market in the past 12 months has been 2%, according to Pictet.

Other risks include illiquidity as this form of debt has no daily pricing and so is not easily tradable. But if the asset is generating a regular, secure long-term return that is at a premium to the yield on government debt, why would they want to sell before the loan matures?

It is easy to understand the popularity behind directly lending senior debt to companies, not least because investors can understand it. They like direct lending for its simplicity. Investors negotiate the terms of a deal and collect the regular repayments, unless there is a default. The returns are higher than those offered by traditional debt products, but with lower protections and concerns over the levels of debt put into some companies, investors need to treat carefully. It does seem that the boom days of the direct lending market are over.

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