Direct Lending funds are becoming an attractive “fixed income alternative” asset class for European institutional investors. The breadth of strategies ranges from high risk/high return “special situations” through to opportunistic strategies and what is referred to as the mainstream direct lending market.
Yields across all three range from six per cent to 15 per cent. As for where DL funds sit within the overall risk category for investors, they straddle syndicated loans (which typically yield between four and eight per cent) and corporate mezzanine (which yields 14 to 17 per cent).
At a breakfast briefing in its London office, Intermediate Capital Group plc, a specialist asset manager and leading player in the fast emerging direct lending space in Europe, gave a presentation on why this is becoming an exciting investment opportunity, particularly with respect to the growing mainstream DL market.
This, said Max Mitchell (pictured), Investment Director at ICG, is where the bulk of asset inflows have been directed to over the last 12 months.
“The mainstream direct lending market is growing in Europe. We’ve seen nearly 200 opportunities in the last 12 months alone. We, and our competitors, are seeing a lot of activity to provide mainstream first-loss senior debt loans to performing mid-market companies,” said Mitchell.
Many of Europe’s mid-market corporates are facing the prospect of their banks turning off the liquidity tap, and it is this need to turn to alternative sources of funding that is beginning to drive the direct lending market.
Indeed, compared to the US, where approximately 84 per cent of debt funding to corporates is provided by institutions, Europe still has a long way to go. Historically, European corporates have relied on bilateral bank relationships to fund their operations. That is now changing as market regulation forces banks to reign in their funding operations.
“There has been European bank retrenchment,” said Jeff Boswell, Head of Portfolio Management at ICG. “They want to remain active but because of regulation (Basel III) and the need to strengthen their balance sheets, their hold sizes in deals are materially reducing. Previously, banks might have held EUR50-100million in any given deal. Now, their sweet spot is probably around EUR15-20million. That gap needs to be filled across Europe, and that’s really how the opportunity set in direct lending has emerged.”
There are typically five things that ICG says investors look for when considering direct lending funds: high cash yield, attractive risk/return, low capital losses, low duration risk and low NAV volatility.
For those that ultimately make the jump, their primary concern with these funds is illiquidity. Does the illiquidity premium that they collect for investing into a fund where each loan typically runs for five to seven years (but which is typically closed out within three to three-and-a-half years) fit within the overall context of their investment portfolio?
Boswell also noted that given that this is still a new market in Europe, investors want to know the structure of the asset class: is it cyclical, how long is it going to be around for?
That then leads to questions regarding manager selection. There are some managers that have operated in the direct lending space in varying forms over the last 10 years or so, but generally speaking, from an investor information perspective there’s not too much information out there.
Investors then have to consider where direct lending funds fit within their portfolio. On the one hand, their illiquidity would typically place them in the “alternatives” bucket with private equity, hedge funds etc. However, because of the regular cash flow generated by annual coupon payments on the underlying loan – which tend to be senior secured loans – these funds look more like fixed income products.
“What we’ve found is that investors are having to create new allocation buckets such as “opportunistic credit”, for direct lending funds, which are basically a sub-set of their broader fixed income portfolio,” added Boswell.
Given that the European loan market is roughly EUR350billion, even if the pendulum towards direct lending swings half way it will create a meaningful size of opportunity. However, putting a quantifiable figure on this new asset class is tricky right now. What is undeniable is that mid-market corporates bereft of funding opportunities, and who lack the size to raise capital in the high yield bond markets, present a real opportunity for direct lending funds.
“In Europe we don’t yet have an efficient capital market solution for mid-market companies. We think the senior secured loan direct lending space may be a partial solution to that,” said Mitchell.
Having the opportunities to put money to work in these direct lending funds is only half the story. What about the returns on offer?
Well, since 2008 the price of loans has enjoyed a significant increase. Senior secured loan returns have doubled: whereas in 2008 they were priced at EURIBOR plus 225 basis points, today they are pricing at EURIBOR plus 500 basis points.
More importantly, this increase does not appear to be linked to increased risk.
“On a risk-adjusted basis, returns per unit of leverage have increased from 40 basis points in 4Q07 to over 100 basis points today. For us, that is a clear indication that this increase in return potential is driven by liquidity constraints rather than risk. It’s being rewarded for supplying liquidity in what is a capital-constrained market, and that’s what makes this an interesting opportunity for institutional investors,” stated Mitchell.
As more institutional players like ICG enter the direct lending space, this could very soon become a highly attractive alternative fixed income option for pension funds to meet their long-term liability obligations. Let the pendulum swing.