Feature


Direct lending is not what it used to be. Institutional investors have become a prominent fixture in the asset class during the past decade, supplying loans totalling hundreds of billions of dollars to mid-mar- ket corporates and government entities. For years the arrangement worked well with the loans returning steady income streams above the coupons offered by investment grade, publicly tradable bonds. How times have changed. With high levels of capital continuing to flow into the asset class, yields are falling and some non-bank lenders are taking greater risks to beat other institutional investors in getting corporates to sign on their dotted line. In some cases, this has included fewer protections for the lender when agreeing the terms of a loan and even lending at ratios that exceed regulators’ rec- ommendations. In short, the increasing popularity of this alternative asset class is seeing investors take more risks for lower returns.


The private debt universe is diverse. The market, which is also known as private credit, includes mezzanine capital, loans secured against property and infrastructure assets, distressed debt, special situations and bridge financing. It also includes direct lending, where the middleman, typically a bank, is removed from the lending process and the assets rarely have daily pricing available at the touch of a button. Such forms of lending are being used by institutional investors to generate higher returns than those offered by traditional fixed income assets. Indeed, net returns in private debt typically range from between 3% to 12%, Aon says. At the time of writing, 30-year gilts yielded less than 1%. In the case of direct lending, investors should expect returns of up to 3% above liquid bank loans.


Private debt also de-risks portfolios by switching out of growth assets and into those providing a consistent stream of income.


It is a popular strategy. In July 2018, Ares Management raised €6.5bn (£5.7bn) for its fourth European direct lending fund, €2bn (£1.7bn) more than targeted and a record


for this market. With leverage, the fund could have up to €10bn (£8.7bn) of firepower. This eclipses its previous direct lending fund, which secured €2.5bn (£2.1bn) of commitments in 2016. So managers are not having too much trou- ble raising new capital for direct lending funds.


Indeed, $45bn (£36.2bn) was


invested in such funds in 2018, according to Preqin, an alternative assets data provider. Although this is down on the $68bn (£54.7bn) collected in the previous year and is only a small part of the $244trn (£195.3trn) global debt market, it is still “too big to ignore”, says Pictet Asset Management.


A BIGGER MARKET


“There is a lot more debt in the world than there was 10-years ago,” says Scott Robert- son, head of financial management at insurer Phoenix.


And a lot of this is private debt. Indeed, large pension schemes, insurers and sover- eign wealth funds are behind many of the more than 80 direct lending firms in Europe today, according to Preqin. This is a sign of how the market has grown since the financial crisis when in 2008 only three such firms were lending directly. “It shows the appetite for anything that can give a return,” says Stuart Trow, a credit strategist at the European Bank for Recon- struction and Development (EBRD). This appetite has certainly found its way into the board room at Phoenix, a consoli- dator of closed-life funds. It has a £24bn fixed income portfolio, of which around £2.5bn is private debt that 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 eco- nomic 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 closes half of the deals it


28 October 2019 portfolio institutional roundtable: Private debt


finds. Those that made the cut include lending Yorkshire Water and Anglian Water £75m and £50m, respectively. Birmingham City Council has borrowed £45m from the insurer. The second-city council passed selection due to a credit rating that matches 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.


A BORROWER’S MARKET


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


Those having the stomach to take on more risk are looking for better returns than those offered by investment-grade corpo- rate 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. “Gen- erally, markets are becoming more pri- vate,” Robertson says.


This interest in funding private businesses is likely to increase from those with private debt strategies. Indeed, more than half (51%) of global investors surveyed by Preqin in 2018 had a positive perception of private debt, with 42% planning to commit more capital to the asset class in the coming 12 months. Only 12% of respondents had a negative view of the asset class. Such a bullish view has created a problem for investors. The asset class’ popularity since the financial crisis has created an abundance of supply. Indeed, direct lend- ing funds had $236bn (£181.9bn) of dry power at the end of 2017, according to Pic- tet Asset Management. This compares to the $667bn (£514bn) of assets the direct lending industry had under management at the time, so competition to put capital to work here has clearly increased. “You have a lot of money chasing fewer and fewer compelling opportunities,” says Supriya Menon, senior multi-asset strate- gist at Pictet. High levels of dry pow- der mixed


with increased competition


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