More Competition, Challenges for Direct Lending, Private Debt Market in 2017

Can the market support the number of new competitors driven by investor interest?

Institutional investors have been raising their allocations to direct lending and private debt opportunities in the past few years as they eye favorable risk-adjusted return profiles and diversification possibilities. For 2017, Preqin reports, 57% of the investors the research firm surveyed are looking to raise their exposure to private debt opportunities. This interest has led to deals this year, such as Aflac’s signing on NXT Capital to manage $500 million in private debt opportunities. Meanwhile, the North Dakota State Investment Board is looking to deploy $200 million in direct-lending opportunities through Cerberus Capital Management.

The past few years have certainly been good for such investments, but how long will this favorable run last? There seem to be challenges ahead this year and fewer opportunities for institutional investors. The rising investor interest in this space also translates into more competition for deals, for one.

Ryan Flanders, New York-based Preqin’s head of private debt products, notes that there is a lot of new interest in this space and money raised is reflecting that interest. “The question is, can the opportunity set stand the number of new entrants? That’s to be determined. We’ve seen a little bit of compression in terms of returns,” Flanders says.

There is also pressure on fund managers to find deals in order to put capital to work, considering that managers are being paid based on invested capital, rather than committed capital. And Flanders is wary of any sort of downturn in the credit markets, considering that many firms that have entered this market haven’t experienced one yet. Another market challenge comes in valuation of private debt loans, which accountants are eyeing more closely every year.

There is also the shadow of rising interest rates. Institutional investor interest in direct lending and private debt opportunities was partly shaped by the historic low interest rate environment of the past several years. As interest rates go up, Tod Trabacco, a managing director with Boston-based Cambridge Associates’ credit investment group, expects commercial banks to get more interested in lending opportunities. “Net interest margin have declined steadily over the past 20 years. As rates rise, net interest margins will rise. So potentially, direct lenders will be seeing greater competition from commercial banks,” according to Trabocco. 

And considering that some of the loans that direct lenders made at higher leverage points that banks tend to avoid have now been paid down, it is also possible for banks to refinance such loans at lower levels of leverage. In these cases, lending funds could engage in strategies such as “offering to finance a dividend to increase leverage and make a loan less refinanceable by banks,” Trabocco says. If such strategies don’t work and a loan is refinanced prior to its maturity, the funds would have to seek out other lending opportunities to meet their return goals.

McChesney expects that these loans are not susceptible to refinancing by banks, considering that direct loans have a different risk and return profile compared to the senior loans the banks prefer. Besides, “Borrowers finding appeal in the structural flexibility and speed of execution associated with the private loans will not necessarily prefer to revert back to the bank-sourced loans.”  

Another potential challenge is that President Trump is interested in financial deregulation, which could do away with many of the Dodd-Frank-related regulations that banks say have rendered them less competitive. Will that also mean more bank interest in direct-lending opportunities? Christopher McChesney, head of alternative fund services with Boston-based Brown Brothers Harriman & Co., says, “It’s very hard to predict the impact of policies that aren’t well-formulated yet. But at a macro level, if banks were to able to extend their lending, there could be more competition for these funds.”  Preqin’s Flanders doesn’t see any near-term impact, but says there could be some fallout in the longer term.

And according to Cambridge Associates’ Trabocco, Dodd-Frank did not have much of an impact on banks’ lending activities, so there will not be any fallout on direct lenders from the repeal of such regulations. One Trump policy that could potentially have a detrimental impact is the taxation of debt financing, but Trabocco doesn’t expect much of a negative impact. “Trump is talking about reducing the tax rate, but at the same time, there is discussion about eliminating the interest expense deduction. I think debt is still going to be cheaper than equity,” he notes. 

Considering all these challenges, are direct-lending and private-debt opportunities generating sufficient alpha to satisfy institutional investors?

Flanders notes that these investments certainly offer “solid returns” with lower volatility, as well as a higher return compared to other fixed-income investments. Trabocco sees alpha for direct-lending investments to be about minimizing losses by making good credit decisions, finding the right sponsors, making the right terms, and maximizing recovery in case anything goes wrong. “There are barriers to entry; you need a team of qualified people to go find investment opportunities, you need a team that works closely together. That’s where the impact comes in. Those barriers are being eroded, so the alpha should come down. And you’re seeing it already because you are seeing spreads compress,” Trabocco says.

Inspite of all these market challenges this year, Preqin’s Flanders reports that there is more than $28 billion in direct lending “dry powder” in North America, as of March, and about $135 billion in private debt-related “dry powder.” To better deal with the competition, it seems managers are looking to develop more custom solutions for institutional investors. McChesney says, “The first wave of these products were more homogenous. And now we’re seeing a greater variety of options in terms of return targets and risk profile coming to market.”

By Poonkulali Thangavelu