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Direct-Lending Funds: A Significant Opportunity or A Tremendous Pitfall?

Jul 24, 2018

 

Financing deals negotiated directly between lenders and borrowers have quickly become an attractive form of asset management. Known as direct-lending, this strategy involves a fund deploying investor capital to profit from lending to companies that are either too small or too risky to receive loans from a bank. According to author Mary Childs in her piece “Wall Street Rushes Into a New Asset Class”, the loans made by these funds are typically smaller than bank loans, usually in a range of $10 million to $250 million. The loans are also likely to be given to firms with EBITDA less than $100 million.

Childs suggests that direct-lending has garnered interest from institutional and retail investors alike. Firms operating across a wide array of asset management strategies, including private equity, hedge funds, and insurance companies, have increasingly incorporated direct-lending into their operations. Companies such as BlackRock and Oaktree Capital Management have continually engaged in direct lending.

Retail investors have also become more involved in the direct-lending space, through the acquisition of shares in publicly traded business development companies, or BDCs. Open-end funds, such as the OFI Carlyle Private Credit fund, are also available to retail investors.

Direct-lending is a potentially lucrative venture, due to the nature of private loans. Direct loans typically carry floating interest rates, becoming more rewarding as interest rates increase. Over the past 12 months, direct-loan funds have provided a 20.3% return, according to data provider Prequin. These funds have returned 13% on average per anum over the last 5 years.

The high yield loan market has rapidly expanded in recent years. In May 2018, $104.6 billion of high-yield loans wee made, according to a Moody’s Investors Service Report, shattering the previous monthly record of $91.4 billion in January 2017. In 2017, $107 billion in private debt was raised by fund managers. According to a Preqin survey, all of the institutional investors interviewed plan to maintain or increase their private debt holdings in the long term.

Numerous factors have contributed to drive the boom in the direct-lending market. When the consensus is for interest rates to rise, floating rate assets such as private loans become increasing attractive. Equity market uncertainty drives investors to seek other methods for asset allocation. An gaining baby-boomer population seeking to retire is now adjusting its portfolio composition, and turning to fixed income assets. Direct-lending also offers investors an opportunity for increased portfolio diversification. While the direct-lending and private debt market certainly provide investors with a significant opportunity for wealth creation, there are concerns that must also be addressed.

Capital has poured into the private debt and direct-lending market so rapidly, that competition for new loans has become fierce. According to a Preqin survey, 70% of fund managers interviewed believe they are facing increased competition from the year prior.

In the face of rising pressure, funds will frequently accept “cov-lite” loan terms. “Cov-lite” deals contain few of the protective covenants that restrict borrowers operations but provide a safety net for investors. It is now estimated that 77.6% of all outstanding loans are “cov-lite”, according to an S&P Global report.

As is the case with any lending venture, there is the possibility that a company will struggle to cover its interest requirements, or default altogether. Another concern is that due to the increased competition for direct-loans, investors aren’t requiring yields and protections that are sufficient enough to protect against downside risk.

Rising interest rates, which make floating rate assets such as direct-loans more attractive, tend to coincide with an economic downturn. Smaller firms which are usually the borrowers of direct-loans, typically have less revenue and less access to financing. This makes them among the most vulnerable, and they potentially face the biggest downside.

To view the article sourced for this piece:

https://www.barrons.com/articles/wall-street-rushes-into-a-new-asset-class-1532111903?mod=hp_highlight_1