University of Michigan Endowment Increases Diversification into Private Debt

New managers would account for 30% of all the endowment’s managers specializing in private credit, distressed and other forms of debt.

The $10.5 billion University of Michigan endowment is making a big bet on small business lenders worldwide.

In an expanded strategy to access the global private lending market, the endowment has added new managers who would account for 30% of all the endowment’s managers specializing in private credit, distressed and other forms of debt. In total, the new managers would receive $400 million. The endowment did not release how many new managers were hired or their names.

The private debt strategy comes at a time when endowments are looking to boost returns in a low-return, global environment, while avoiding excessive risk. A Preqin study found that the alternative financing market is “progressively expanding throughout Europe to become one of the mainstream options offered to corporates and private equity firms to access long-term debt financing.” The study also noted that 46% of investors plan to increase their private debt allocations in 2016, while there is $523 billion in total assets under management in the private debt industry as of June 2015, an increase of $40 billion from year-end 2014.

The Michigan endowment is the 10th-largest college endowment and uses about 250 managers as of June 30, 2016. Since then, the university regents approved additional hiring, including investing up to $70 million in a pair of Asia special situations group credit funds, according to Bloomberg. 

In addition, records show the endowment invested in nine credit managers since June 30, 2016, including Black Toro Capital Fund II (about $53 million) that operates in Spain; Abax Global Capital ($40 million) that lends to small- and medium-sized companies in China; and, Emet Capital Management ($50 million) that invests in distressed municipal bonds collateralized by student and senior housing in New York.

Alternative Lending Fills a Void Created by Dodd-Frank

Renewed activity in the private lending and credit markets to small- and medium sized US companies is the result of capital requirement rules in the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010. Under Title I rules, banks with more than $50 billion in assets must cap credit exposures to a single counterparty with assets over $50 billion at 25% of a bank holding company’s total capital. Commercial loans are covered under Title VI.

While Dodd-Frank is in effect, the credit market is open to non-bank lenders. However, the Trump administration has vowed to repeal all or sections of Dodd-Frank, so this marketplace could look different if these changes are made.

In Europe, banks are under more stress. A recent report from Altficredit found that banks have been shrinking their balance sheets since the 2007 recession. In 2008, the total assets of European banks stood at about $35 trillion and declined to $29 trillion by 2015, according to the European Central Bank data as of 2016.

As a focused asset class, private lending can add incremental return for a large, diversified portfolio, such as the University of Michigan endowment, but these returns could be short-lived, according to Richard Steinberg, president and CIO of Steinberg Global Asset Management, Boca Raton, Fla. The current situation is similar to mezzanine financing in the early-2000s, when returns went from 12% to almost zero due to cross-collateralization, Steinberg said.  As an alternative, he suggested that since the European central banks are following a similar playbook to the US Federal Reserve, it could make sense to invest in banks directly as regulations evolve.

Yet with more stress on balance sheets, a low-rate environment and higher capital requirements, the lending business model in Europe is changing. “I see strong evidence that the conviction among key decision and policy makers in Europe is leaning towards increased lending via alternative sources. Over-reliance on banks made us too vulnerable and constrained our economic development and we need to increase resilience via diversifying funding sources towards the European economy,” Gabriella Kindert of Altficredit said in a report.

While this market is expected to grow this year, especially in financial technology-related firms, institutional investors should temper their expectations of high returns, Kindert said.

“Investors seem to have high return expectations from private debt instruments that need to be managed,” she said. “At the moment, a high percentage of investments are going to the highest-risk basket in private debt (e.g., direct lending with return exceptions of 6%-10%). The potential private debt universe is a lot larger than lending at 6%-10% to sub-investment-grade companies.”

Kindert said European banks have about 1.5% net interest margin and lend at an average interest rate of 2.5%. However, “the bulk of the traditional banking products are safer assets and can be an excellent alternative to traditional fixed-income products. Some of these new assets classes [like Dutch mortgages] have been favored by many institutional investors recently and a lot of similar product initiatives are likely to come.”

By Chuck Epstein