Direct Lending: What’s Different Now?

Mar 14 2017 | 8:43pm ET

Senior direct lending funds have become riskier over the past four years, with leverage creeping up and unitranche loans becoming increasingly dominant as managers try to keep IRR expectations on track despite spread compression, according to new research from bfinance. 

At the same time, competition for deals is intense and dry powder abounds despite reduced fundraising, investor appetite for purer senior debt vehicles and new European demand for U.S. direct lending, the company said in a statement. The research is compiled in Direct Lending – What’s Different Now?, a new market intelligence paper from bfinance that draws on insights from 2016-17 consultancy work and, in particular, data from five senior direct lending searches conducted between November 2016 and February 2017. 

More competition, greater risk

Fundraising, although down on 2015, remained strong in 2016. According to Preqin, private debt funds raised $73.8 billion in 2016, while "direct lending" funds raised $43 billion, with the level of dry powder reaching a new peak of over $220 billion. There has been significant like-for-like spread compression in the upper-mid market. While mangers still expect returns above 8% in unlevered senior funds, a less conservative profile is required to achieve this. Given this very competitive environment we expect significant performance dispersion between upper and lower quartile managers.

Although direct lending has expanded rapidly over the past few years, many argue that there is still room for further growth, citing overall corporate lending volumes, upcoming regulatory changes and the potential for growth in the 'less crowded' sponsor-less sector.  Default rates have remained low, averaging below 2% for direct lending and around 3-4% for leveraged loans. Yet the risk picture is concerning. Leverage (debt/EBITDA) has crept upwards and deal terms have eroded with the spread of "cov-lite" arrangements.

Unitranche loans have brought many advantages but structures should be closely examined and handled with care. These can take many forms and appear to be moving away from their original simple structure with lenders taking on more risk in the capital stack and higher multiples.

Banks have pressed to regain market share in private corporate lending, exploring more bespoke and creative models including a recent spate of manager/bank unitranche financing partnerships such as SMBC/Park Square and Varagon/Ares. Bank syndication is also in a very healthy state relative to 2008 and is the source of much manager dealflow. The relationship between banks and asset managers is more often symbiotic than competitive.

From a pure manager selection perspective, bfinance has identified four primary themes that are of particular relevance today based on recent client engagements: new entrants and the rapid evolution of the asset manager universe; demand for "purer" senior debt strategies, European appetite for U.S. investment, and the trend towards lower headline fees.

1) Composition of the private debt manager roster is evolving with new entrants continuing to emerge

The most recent bfinance searches in for senior private corporate debt funds (Europe, U.S. and Global) reveal that 27% of the available pooled vehicles represented the manager's first-ever senior fund. In several cases, these are firms that have previously managed non-senior funds. In other cases, these are entirely new entrants in the private debt arena, most often from private equity firms.

The changing composition of the roster adds complexity to a marketplace already characterized by fluctuating availability due to the closed-ended nature of most vehicles. This makes up-to-date provider analysis particularly crucial. It also affects the way in which managers should be assessed, such as a focus on personal rather than institutional track record.

2) Growing appetite among pension funds and insurers for purer senior debt funds

While plenty of asset owners and managers are hungry to reach for yield in today's compressed market, a significant proportion of allocators are finding the current roster of senior direct lending funds too risk-seeking for their needs. More than half permit over 20% of the fund to be invested in subordinated debt.

3) European asset owners are increasingly keen to invest in U.S. private debt

Many European investors have so far steered clear of the very different US market due to the greater leverage at fund level, unfavorable taxes and currency hedging costs involved. Yet willingness to consider different types of risk, greater experience in the asset class and views on the current opportunity set have all contributed to changing demands.

Prominent U.S. managers have introduced European vehicles in order to take advantage of this dynamic. Yet, on the whole, the private debt industry does not service European appetite for “global” or U.S. private debt investment as effectively as investors might wish. While further product development would clearly be helpful, asset owners might also consider recalibrating views on aspects such as leverage and collateral in order to tap U.S. opportunities more effectively, paying close attention to the many differences in how American and European lenders actually generate returns.

“As a group, U.S. senior debt funds tend to produce higher returns than their European counterparts, in large part due to the additional leverage they use at the fund level,” noted bfinance associate Dharmy Rai, one of the authors of the paper. “Yet there are many other differences in the way that European and US managers generate their income and overall IRR. For instance, origination fees make up a greater portion of overall yield for European managers than US peers. European investors looking towards U.S. direct lending opportunities should be sensitive to structural differences and impact of hedging and tax consideration."

4) Trend towards lower headline fees, although structures must be analyzed with care 

Management fees of 1% plus carry of 15% with a catch-up appears to be the current industry norm for senior debt funds, with considerable flexibility for negotiating further downwards if investing in size, particularly in management fees. Yet hurdle rates, catch-up levels and administrative fees prove critical to overall leakage and should be handled with care.

Fee structures and administrative charges are of paramount importance in an asset class where up to 25% of gross returns can potentially be swallowed up by costs. Yet before considering fee numbers, it is necessary to understand fee structures. Ultimately, considerations such as where the hurdle rate is set and whether the manager uses a catch-up structure can have far more influence on take-home figures than whether the carry percentage is 10 or 15 percent.

In addition to Rai, the new report was authored by Kathryn Saklatvala, Global Content Director, and Niels Bodenheim, Director of Private Markets.

“Within ten years, unitranche has gone from novel concept to instrument of choice,” said Bodenheim in the statement. “For managers, the unitranche has provided a way of boosting returns without adding further to the proportion of subordinated debt in portfolios, since it is technically first-lien. Investors, however, should keep a careful eye on the structures and terms underpinning these loans. Increasingly complex models have emerged. We’re seeing lenders introducing a component of PIK relative to cashpay in unitranche, enhancing returns but creating a more back-ended structure (deeper J-curve). We’re also seeing more cases where the unitranche is going deeper into the capital stack, which can be a source of concern for a loan classified as senior debt. 

“Cash flow debt multiples are now at the upper end of historical levels, with figures of 6x or higher deserving particular scrutiny,” he added. “Most importantly, although we have seen some restructuring of unitranche deals, we have not yet seen how they fare through a full credit cycle." 

The rise of direct lending, and of private debt investment in general, has undoubtedly been one of the biggest themes in post-GFC institutional investment, noted bfinance’s director of content Kathryn Saklatvala. “When you look at where investors have increased allocations, where they've added new allocations, what they want to talk about, [direct lending] has been top of the list for several years. The investment case relative to public fixed income practically wrote itself, while the story of how banks pulled back from corporate lending in Europe was a powerful and intuitive one. 

But 2017 is very different from 2011/12, Saklatvala points out. “Although the overall risk/reward equation is still attractive relative to public corporate debt, the current climate is more nuanced. New challenges include the increased risks in senior debt funds, new entrants in the manager roster and increasingly complex loan structures. We expect significant performance dispersion between upper and lower quartile managers, particularly through the end of the current credit cycle."

London-based bfinance provides advisory solutions to institutional investors worldwide. These include investment implementation, investment strategy design, investment manager search and selection, analytics and monitoring. The company completed private debt mandates worth over $1.25 billion last year, of which nearly $930 million comprised direct corporate lending.


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