Investors' clamor for private credit could hurt returns

Credit managers are raising mountains of capital for private credit vehicles just as some industry insiders recommend investor caution in light of faltering returns.

In a search for higher investment returns, asset owners continue to commit billions to a wide range of credit strategies including direct lending, distressed and stressed debt, structured products and mezzanine debt. But industry observers say these big inflows are affecting returns as managers find it harder to put so much money to work under tight market conditions.

Private debt assets under management worldwide hit an industry peak of $595 billion as of June 30, the 10th consecutive year of increases, data from London-based researcher Preqin show. 

At the same time, private credit returns for newer funds are lower than the funds raised just after the financial crisis. For example, direct lending funds raised in 2014 returned a net internal rate of return of 8%, the same as 2013 vintage direct lending funds but down from 14% IRR of funds raised in 2008, Preqin data show. The same is true for distressed debt and mezzanine 2014 vintage funds, which had a 1% net IRR and a 7% net IRR, respectively, a far cry from the 16% and mezzanine net IRR of 10%.

As a group, private debt strategies have underperformed private equity.

Private debt funds earned a net IRR of 9.53% for the five years ended June 16, compared with private equity fund returns for the same time period of 13.3%, according to data provided by Preqin.

Even so, managers are having little trouble raising credit funds.

Sixty-three percent of credit funds closed in the first quarter of 2017 exceeded their fundraising target, the largest percentage in the last five years, Preqin data show. Dry powder reached $200 billion as of March 31, up 2% from Dec. 31, but second in size to the record amount of unspent capital commitments held by credit managers — $215 billion — at year-end 2015.

“Conditions are competitive and we are seeing a little bit of the late cycle excesses,” said Bill Sacher, partner and head of credit at alternative investment fund-of-funds manager Adams Street Partners LLC, Chicago.

These excesses include high valuations, higher leverage levels and aggressive calculations of expected returns, he said.

Still, returns remain attractive compared with other sectors, Mr. Sacher said.

The median return for the entire domestic fixed-income universe was 3.18% for the 12 months ended Dec. 31, according to Morningstar Inc.'s separate account/collective investment trust database.

“There's no question that the private credit space has become incredibly hot, crowded over the last couple of years,” said John Martin, managing partner and co-chief executive officer of middle market credit firm Antares Capital LP.

Antares Capital was formed when the Canada Pension Plan Investment Board bought GE Capital's private equity financing arm in 2015. Alternative investments firm Northleaf Capital Partners acquired a 16% stake in the firm last year from CPPIB, which manages the assets of the C$298.1 billion ($221.3 billion) Canada Pension Plan, Ottawa.

“When we spun out of GE Capital ... it shot a brighter spotlight on (credit),” Mr. Martin said.

Antares invests in the senior-most position in the capital stack, which is safer than more junior loans and provides a more predictable return, he said.

“And with a little leverage (returns) look very attractive” compared to bonds earning 4.4% to 5.5%, Mr. Martin said.

Senior debt compares favorably to high-yield bonds in a rising interest rate environment because Antares invests in floating-rate loans that increase with interest rate hikes. High-yield rates are fixed, he said.

What's more, the capital moving into credit is providing ready buyers for loans Antares originates but doesn't want to hold on its books.

Still, it is late in the economic cycle and leverage levels in deals are bumping up toward historic heights and terms are becoming very aggressive, he said.

Lending spreads — the difference between the lender's cost of capital and what the lender earns on the loan — “have come in a bit,” Mr. Martin said.

Managers say they are responding to investor demand: Growing familiarity with alternative credit strategies has enhanced their appeal to asset owners.

“A lot of institutional investors have already had good experience with credit and are ready to invest more,” said Jack Yang, the New York-based head of the Americas at Alcentra, a BNY Mellon investment boutique that specializes in subinvestment-grade corporate credit.

Alcentra managed $30.8 billion in alternative credit strategies as of Dec. 31.

At BlackRock Inc., portfolio construction of many of the firm's clients has evolved to include rates, credit, equity and alternatives, said James E. Keenan, managing director, co-head of global credit and chief investment officer in New York.

He also noted alternative credit's midteens return stream is a “natural fit” for liability-driven investment strategies when the fixed-income allocations of 85% or more of corporate LDI-based fixed-income portfolios are only yielding 3%.

Alternative credit offers “good optionality” because the spectrum of investment strategies is wide, as is the liquidity range of underlying credit instruments, Alcentra's Mr. Yang said.

Institutional commitments to distressed debt, special situations, mezzanine, structure credit and multiasset credit strategies hit a high of $18.3 billion in 2016, Pensions & Investments' analysis of reported hiring activity showed.

At $7.4 billion, committed assets in first quarter ended March 31 are the highest three-month total since Jan. 1, 2010, and if the pace continues, new money earmarked for alternative credit in 2017 likely will hit another high.

Actual commitment levels likely are higher because some institutions don't make their investment activity public. The 900 alternative credit moves analyzed by P&I were predominantly by U.S. public pension plans.

Where lots of institutional money is going money managers follow, and observers said the alternative credit arena is getting crowded, pushing up prices and lowering returns.

“Credit is here to stay, said Jeff Davis, partner at Rowayton, Conn.-based placement agent firm Eaton Partners LLC. “We get three to five inquiries a week from managers to raise one credit strategy or another, and that's no exaggeration.”

There was a combined 283 private debt vehicles fundraising worldwide targeting a combined $112 billion in capital, according to Preqin. Direct lending strategies are on pace to continue raising the majority of investor capital with 126 funds targeting a combined $43 billion.

Still, larger alternative credit managers are cognizant of the limitations current market conditions impose on their ability to put investor money to work.

“Even if market capacity was larger, we would still be worried about our own capacity as a manager. It's a question we wrestle with a lot,” said Ilfryn Carstairs, partner and co-CIO, of multicredit shop Varde Partners LP, Minneapolis.

Varde Partners manages about $12 billion in credit strategies. Mr. Carstairs said his teams have “a little bit of a 'just in time' attitude about raising assets for new funds.

“We like to be at a place where we have a little less capital than we could put to work,” he said.

Some smaller credit managers insist they have a competitive advantage over larger competitors.

“AUM of $5 billion or less is our competitive advantage,” said Jon Bauer, co-founder, CEO and CIO of Contrarian Capital Management LLC, Greenwich, Conn., a distressed debt hedge fund manager that has $4.2 billion of assets under management. “We poke around in the niches, which is very labor-intensive. We could not do this if we had to put $20 billion to work and could only buy into very large deals. There isn't enough available paper.”

Jared “Jed” Nussbaum, founder and managing partner of new firm Nut Tree Capital Mangement LP, New York, agrees that smaller managers have a competitive edge. Nut Tree's is investing in the high-yield market which is dominated by small-to-midsized issuers “and is very constrained when it comes to how large an investment you can put to work there,” Mr. Nussbaum said.

The start-up firm manages $400 million in high-yield value, distressed and stressed credit instruments, mostly in North America.

Mr. Nussbaum stressed: “At our size, we can do what made hedge funds great 30 years ago.”

A report obtained by P&I showed that Nut Tree's flagship credit strategy returned 27.3% in the 12-months ended Jan. 31, its first year of operation.

Private equity firms, too, are expanding into credit.

“The elongated period of low-interest-rate environment and the challenges pension funds, endowments and foundations investing for the long term in this environment, have created an almost insatiable demand for yield,” said John Toomey, managing director in the Boston office of fund-of-funds manager HarbourVest Partners LLC. HarbourVest has about $40 billion in assets.

The firm on April 6 closed its first dedicated credit fund, a $375 million mezzanine fund. The fund lends to small to middle-market companies, a less efficient end of the market. Smaller companies have less credit available to them, he said.

Before HarbourVest raised its first credit fund, the firm had made mezzanine loans through its commingled fund that had a direct loan allocation, Mr. Toomey said.

Within the next 12 months, HarbourVest executives plan to expand their credit offerings, including possibly direct lending to smaller companies, Mr. Toomey said.

The growth of private credit has resulted in emergence of specialists, said Eaton Partners' Mr. Davis.

Specialty credit and asset-based lending strategies are popular. These managers invest in everything from aircraft leasing to maritime credit, Mr. Davis said.

Over the past 18 to 24 months, a new credit strategy — energy credit funds — has come to market, he said. Private equity firms that had focused on investing equity in energy businesses, especially upstream oil and gas exploration, are struggling, he said.

“There are a lot of credit opportunities to invest in companies that they (energy-focused private equity firms) would have typically invested equity,” Mr. Davis said.