Direct lending – end of the good times?

Are times, and returns, changing for investors in the direct lending space?

Increasing numbers of pension fund investors are turning to direct lending strategies, attracted by their solid risk/return credentials, but with fund managers running up huge piles of uninvested capital, many are now questioning if the strategies have run out of steam.
Following the financial crisis, as banks retrenched and the collateralised loan obligation (CLO) market shrank in size, pension schemes – stepping into the breach – found that lending directly to small and mid-sized corporates provided them with steady, attractive yields that were scarce at a time of volatile equity and money markets.
Data from Preqin found that assets under management for direct lending funds, which were at $18bn at the end of December 2007, jumped to $159bn at the end of December 2016. Assets under management have grown by around $4bn to $163bn as at March 2017. Assets raised by global direct lending funds peaked at £13bn in the first half of 2017, according to Preqin.
Ryan Flanders, head of private debt products at Preqin, said in the long-running, low interest rate environment, many fixed-income products had failed to provide adequate returns for pension funds.
“In that context, it makes sense that pension funds in particular are seeking out direct lending investments as a means to receive higher rates of return while maintaining a relatively low risk/return profile,” he said.
Direct lending now accounts for 10% of Europe’s loan market, according to Thomson Reuters data. Fund manager Hermes said this rapid growth had been fuelled by a surge of interest from long-term investors such as pension funds, attracted by an illiquidity premium of almost 60bps, as well as a desire for strong yields that were lowly correlated with listed markets, capital preservation and inflation protection.
Richard McIndoe, Director of the £20bn Strathclyde Pension Fund, which first ventured into direct lending through a deal to fund the construction of the Athletes’ village for the 2014 Commonwealth Games in Glasgow, said that allocation had achieved a “double-digit” return. The fund has since committed £500m to the private debt market funds, investing through funds managed by asset managers.
Most UK pension schemes invest in direct lending through fund managers, but larger pension schemes, with strong in-house capabilities, lend directly to borrowers.
Colin Pratt, Investment Manager at the £3bn Leicestershire Pension Fund, said his pension fund has allocated £240m so far to direct lending strategies. The pension scheme has invested through funds managed by various fund managers, and Pratt said the direct lending allocation was not accounted for any differently to a credit portfolio such as a corporate bond portfolio in the scheme’s asset allocation. “Direct lending is one of the more attractive parts of the credit spectrum and currently offers us yields of 5-6% over Libor, which is a nice, steady return,” said Pratt.
He added: “Our investments in direct lending has done exactly what we expected- while there have been no positive surprises, we have had no negative shocks either.
However, Pratt noted that with more investors than ever before, opportunities in the direct lending market “would not last forever”. “With more and more capital coming into the market, returns will be diminished as we are likely to see too much capital and the too few opportunities getting arbitraged away,” he said.As at March 2017, ‘dry powder’ or un-invested capital stood at $70bn, according to Preqin. Niels Bodenheim, Senior Director of Private Credit Research at bfinance, said that while the risk/reward equation of investing in direct lending strategies in 2017, was still attractive in relative terms, it was “somewhat less favourable” than it was four years ago.
The huge stockpile of un-invested capital had inevitably lead to pressures on fund managers to deploy, and Bodenheim said this had already resulted in a “relaxation” of certain aspects of lending.

“There is more capital and more competition, so we are seeing a certain leniency creeping into credit fundamentals” – Niels Bodenheim, bfinance

“There is more capital and there is more competition, so we are seeing a certain leniency creeping into credit fundamentals. Companies that would not have been lent to five years ago, are now receiving funding and I think we are going to see more of this happening,” he said.
Preqin’s Flanders said direct lending had been impacted from the dual challenges of too much available capital and too much competition seen elsewhere in the alternatives assets industry.
“Investors are faced with an ever-growing number of funds seeking investment, and so the challenges in choosing the right fund are growing, while at the same time, fund managers’ available capital waiting to be deployed has also grown.
“This has increased competition among deal makers for the best opportunities, and pushed up asset pricing, leading to concerns over the potential future returns for direct lending funds,” he said.
Despite this, Flanders noted that direct lending remained an attractive prospect for many pension funds, and said he expected to continue to see significant amounts of capital allocated to the asset class.
This view is echoed by Graeme Delaney-Smith, Head of European Direct Lending at Alcentra, part of BNY Mellon Investment Management, who said he expected pension funds to continue allocating to the strategy, with some now looking to increase their allocation to direct lending.
Alcentra has raised some £6bn from investors through direct lending since 2013, with some 57% coming from pension funds.
Highlighting the role played by ESG in the firm’s investment decisions, Delaney-Smith said an ESG committee, which sat outside the firm’s regular investment committee, had been established to scrutinise potential investments in grey areas.
“This committee rejected a defence manufacturer, and also recently turned down an aircraft part manufacturer which made mechanisms that could be deployed in forest fires, but could also be used also for carrying missiles, because it was not considered appropriate,” he said.  
bfinance’s Bodenheim said that while ESG factors were implemented by different investors in varying degrees, most investors applied some ESG criteria in their investments.
“So while some investors look at sector exclusions – for example, tobacco and fossil fuels – others try and ensure that more detailed criteria are met throughout the investment process,” he said.