Institutional investors need to think carefully about where the increasingly popular direct lending strategy sits within their asset allocation.
“The main driver is the lack of yielding return within the traditional fixed-income markets,” said Ryan Flanders, head of private debt products at Preqin in New York. “The private credit space is a unique opportunity to find good risk-reward within the fixed-income environment.” Investors seem willing to take on some illiquidity risk, particularly since it gives them a premium, plus yields in the high single to low double digits.
“Both pension funds and life insurance companies … are interested in direct lending,” said Laurent Gueunier, head of alternative debt at BNP Paribas Investment Partners in Paris. “The problem is that now in the direct lending field you mix everything from infrastructure, to real estate, to corporate financing — senior to junior financing. It is direct lending but with different assets, and different kinds of risk profiles. So first you have to know where you invest your money, which kinds of assets you are choosing, and what kind of risk and volatility you are ready to take.” It is only then that investors can begin to investigate their options.
Terry Harris, head of portfolio management, global private finance, at Babson Capital Management LLC, based in Charlotte, N.C., said: “In Europe there is particularly strong interest in direct lending. I feel like a lot of European investors have progressed to the point that they appreciate this as a fixed-income asset class.” In the U.S., he said, pension funds are also beginning to think of it as fixed income, “but many are still thinking of it as an alternative investment.”
Fobel said the basic premise of direct lending is to take advantage of the funding gap existing in the market where banks have retreated from funding businesses –primarily as a result of the constraints around the Basel III regulation.
“We have seen very significant growth in direct lending funds, largely because what they offer is significant yield enhancement to what most investors can get from their traditional fixed-income portfolios,” said Mr. Fobel. In the current low interest rate environment and with pension funds and insurance companies having long term funding requirements, that is “critically important.”
However, direct lending will “never be a complete substitute for fixed-income portfolios, as it is too small as an asset class – but as a supplement it certainly offers very significant yield enhancement,” he said. Assets are in theory relatively low risk too – “certainly the good funds are trying to target deals where they are investing primarily in senior secured loans – that is the safest part of the capital structure – on relatively conservative capital structures.” With an historical 3% default rate, and a 60% rate of recovery, these strategies can yield an attractive risk-adjusted return, he said.
For the most part, private debt opportunities sit in the alternatives bucket of an investor’s asset allocation, said Declan Canavan, London-based Europe, the Middle East and Africa head of alternatives at J.P. Morgan Asset Management. “However, the due diligence and work to understand strategies and select managers is very akin to fixed income or a core asset class. It is not necessarily the risk that makes it alternative, but the delivery mechanism,” he said.
“To me, it is not clear yet for pension funds or insurers where to put this allocation — is it pure alternative? Yes, if you consider it is high yielding. But when it comes to direct lending financing … it is closer to a corporate bond. The allocation is a moving target — once direct lending is a bit more mature, (investors) can differentiate between asset classes. We see an evolution of direct lending, moving out of alternatives (and) being part of a mainstream allocation,” said Mr. Gueunier.