Direct lending: Dry powder to force fund consolidation
Large funds will dominate; banks offer increasingly aggressive structuring.
Having driven the great bank disintermediation trade of the last few years, investor enthusiasm for private debt might be on the wane. Data provider Preqin says $16.5 billion was raised via 25 private debt funds in the second quarter this year, down from $20.8 billion in the first quarter of the year and $23 billion in the fourth quarter of 2014.
“After a record year for fundraising in 2013, 2014 saw a notable drop in the amount of capital raised, and these figures represent a further slowdown,” says Ryan Flanders, head of private debt products at Preqin. “One possible explanation for the falling fundraising levels is the build up of dry powder. With unspent capital now at record levels, investors may be hesitant about committing to new funds until they see existing investments deployed into viable opportunities.”
A lot of big participants have raised second funds and will be back in the market with their third fund in another 18 months or so
Whether or not this represents a brief pause in the market’s growth or something slightly more permanent is a matter of debate. “The amount of money coming in to direct lending feels like it has slowed,” says Callum Bell, head of corporate and acquisition finance at Investec in London.
“Some very large funds have been raised that have a lot of money to put to work. Money has come in to the asset class quickly for all the right reasons but things feel a little overdone now if you compare monies raised and private debt demand particularly in an environment where banks have strong appetite to lend and protect their corporate relationships.”
He believes it will be several years before it becomes clear how successful some of these private debt funds have been. “The vast majority of funds are still in the deployment phase. In two to three years we will start to see better how well they have deployed and at what returns.”
Others argue that fundraising is likely to pick up again soon. “There is cyclicality in the market and fundraising is taking a temporary breather,” says Max Mitchell, director in credit fund management at London-based specialist asset manager ICG, which recently raised €3 billion for its fourth direct lending fund, ICG Europe Fund VI.
“A lot of big participants in the market have raised second funds and will be back in the market with their third fund in another 18 months or so.”
Despite the slowdown in fundraising, European mid-market firms remain an attractive proposition for regional and global non-bank lenders.
Pressure on returns
In July, Oppenheimer Europe set up a European debt capital markets and syndication business. “In Europe we will focus our efforts on issuers looking to borrow less than €500 million,” Robert Lowenthal, senior managing director of fixed income at Oppenheimer Holdings tells Euromoney. “We are interested in established, cash flow positive corporate entities where the deal size or other attributes of the deal might not be easily addressed by bulge bracket investment banks.”
The problem is that a lot of other people are too, which will put pressure on returns for funds and banks alike.
“Under current conditions, if debt funds stick to the mandates under which they raised capital it will be more difficult to deploy and hit their yield targets,” warns Bell. “They have the options to go down the yield curve, up the risk curve or put less money out there. They will likely go for the former two. To offset yield pressures, there has also been increased utilisation of fund leverage (so-called debt-on-debt) to help juice up returns in a low yield environment.”
Yet as the events of the last seven years have shown, adding leverage to the system doesn’t always work out so well.
It seems inevitable that some of the private debt funds that have been raised in recent years will not survive. “Over the next five years we will see continued growth in non-bank lending as a source of capital for non-investment grade firms but we do expect consolidation,” says Mitchell. “There will be between five and 10 very large pan European asset managers that will dominate the market. A lot of tier-two and tier-three players will be pushed out and won’t raise a successor fund. If all you are is a commoditized player you will be commoditized in pricing and terms.”
Recent research supports this theory: according to Private Debt Investor, the largest three such managers, Oaktree Capital Management, Lone Star Funds and M&G Investments, have raised more than $105 billion in the last five years.
The advent of very large funds could also put pressure on the banks because of the size of holds they are prepared to make. ICG, for example, has taken tickets as large as £200 million in a single deal.
“We manage our portfolio in very much the same way as the banks do and look to construct a portfolio to deliver a balance of risk across industry, geography and individual borrowers,” Mitchell says. “However, given our significant assets under management, we can achieve quite large hold positions within acceptable concentration limits and are comfortable taking positions of £200 million or more. In a deal where we write a £200 million ticket we would be either a bilateral lender or by far the largest lender.
"We would have control over the situation and have strong rights and interaction with the borrower to help to manage and protect our downside. This type of investing is not simply a grossed up version of a participation in a syndicated loan.”
It is hard for the banks to compete with this kind of firepower and some are responding with increasingly borrower-friendly lending structures.
“Increased competitive pressures have led to lower levels of discipline particularly within banks who have taken the threat of the private debt funds very much to heart,” says Bell. “We have seen the development of increased credit risk into structures such as covenant-lite and bullet tranches. In my opinion, the price advantage that banks still offer vis-à-vis debt funds does not warrant this level of structuring and control dilution.”
However, Mitchell at ICG reckons that discipline is still holding. “We are happy to work with the banks and don’t think that there is wholesale aggressive behaviour,” he says. “If it is a business they know well, and they have strong conviction on the credit, then a lender might be more aggressive but we think that overall the mid-market has retained good lending discipline.”
How much longer this remains the case is clearly up for debate.