The emergence of direct lending funds to answer private investors’ needs.
The lack of value in fixed income assets and the rising volatility in equities has created renewed interest in alternative investments and direct lending strategies, which have become a key component of well-diversified investment portfolios. Initially, the asset class was mostly the realm of sophisticated investors, but it has developed into products now available to much smaller portfolios and private investors.
Nevertheless, private banking clients remain underexposed to alternatives. Despite the rising transparency and regulations, hedge funds continue to suffer from image problems due to some bad practices in the past. Private equity funds offer the most attractive risk/reward profile, but the lack of liquidity can be an obstacle for private investors that have uncertainties surrounding the adequate time horizon and risk profile. This is the main differentiator between private investors and big institutional investors such as endowments and sovereign wealth funds, which have a very consistent investment strategy based on long-term objectives. The most prominent example is the asset allocation of the Yale Endowment with 50% in illiquid assets and around 80% in alternatives overall, including liquid alternatives. Pension funds have also increased their exposure to alternatives, such as direct lending funds, from 5% in 1995 to around 25% now.
However, there are new segments in the alternatives space that could help to overcome the (sentimental) hurdles that discourage private investors from investing. For example, investors have recently begun to expand into providing debt to businesses, an area traditionally dominated by banks. The disintermediation process is part of a broader global trend known as shadow banking or shadow lending; whereby non-bank actors seek to provide credit to companies.
The growth of private debt funds has been tremendous with very attractive risk-adjusted returns for investors. The trend is driven by three factors: Firstly, the post-crisis financial regulatory reforms have led banks to reduce their lending activities, particularly to small and medium-sized businesses. Secondly, the demand for credit from businesses has not fallen to the same degree, leading to unmet demand. And thirdly, the demand from institutional investors for debt that yields more than government debt remains robust. Historically, the private debt market consisted of specialized funds that provided mezzanine debt, which sits between equity and secured/senior debt in the capital structure, or distressed debt, which is owed by companies near bankruptcy. Following the financial crisis, a third type of fund emerged. Known as direct lending funds, these funds extend credit directly to businesses or acquire debt issued by banks with the express purpose of selling it to investors.
Direct lending is also a fantastic protection against the possible corrosive effect of interest rates. This is because the duration of such loans is much shorter that conventional ones coming from banks and securities firm. Thereby, if the interest rates are to be lowered, as they have for quite some time, this will not affect the value of the loan. The typical repayment structure of such instruments feature all-cash coupons, which are paid with the principal at maturity.
Leading alternative investors have all expanded their product offerings to include private debt funds. They are joined by many specialized new firms. The strong demand by institutional investors has enabled these funds to expand rapidly in size. Collectively, more than 500 private equity style debt funds have been raised since 2009. The private debt industry has grown its assets three-fold in the last ten years, hitting a record last year of $638 billion despite increased distributions to investors, with 25% of that coming from direct lending funds.
This has been also observed in big investment firms’ strategies in the past ten years. For example, Blackstone has expanded its private debt and credit allocation from USD 10 billion to USD 150 billion from 2007 to 2020 in assets under management. Apollo has shifted from USD 20 billion to USD 323 billion in that regard -between 2011 and 2020. Not all this capital is allocated towards direct lending funds, but this paradigm shift still illustrates the increased momentum towards such investment vehicles. Furthermore, the giant’s shift to more asset allocation in private debt delivers a strong message to the rest of the industry: this market is here to last.
Direct lending funds are highly suitable for private investors. There is a wide range of strategies such as real estate bridge loans, equipment leasing, trade finance, consumer loans, just to name a few. The generally offer high single digit returns with strong collaterals, low volatility and very low correlation to traditional asset classes. There are specialized funds that offer monthly or quarterly liquidity. However, these are also more complex and sophisticated, so an adequate analysis and good advice are presented as essential to make the right decisions and not take unnecessary risks.