More institutional investors are considering direct-lending strategies in an attempt to capitalize on a supply/demand imbalance in the credit markets and boost returns in their fixed-income portfolios. With many banks still tightly holding their lending purse strings, pension funds are stepping in to provide middle-market businesses with financing. Plan sponsors and consultants say direct middle-market loans, in addition to delivering better returns than high-yield debt, are relatively recession-proof thanks to high recovery rates. Floating interest rates are another plus, as they protect investments against rising rates that hurt bond portfolios.
Since Jan. 1, U.S. pension funds have made at least 14 new commitments to direct-lending strategies, doling out about $790 million, according to iiSEARCHES data (see chart). This compares to some $475 million invested throughout all of 2012. Several pension funds have held discussions on the investment class this year, and industry practitioners agree that direct lending’s popularity is on the upswing. “More and more players are entering the U.S. market right now,” said Neil Sheth, partner and director of hedge fund research at consulting firm NEPC.
Unlike investing in bank loans, which have also been popular among pension funds recently, direct loans are not syndicated and generally carry a higher interest rate. This difference in interest rates represents a spread of 200-300 basis points over bank loans, Sheth estimates. Asset managers that run direct-lending strategies typically make senior-secured loans to small- or mid-sized companies that cannot secure lines of credit from traditional lending entities such as banks. The “senior-secured” status reduces the default risk. “There’s an attractive spread over investment grade and high-yield debt,” Sheth said. “And you’re senior in the capital structure, which is preferential to high-yield, where you’re lower.”
Floating interest rates are another attractive feature of direct loans. Girard Miller, chief investment officer of the $10.7 billion Orange County Employees’ Retirement System, said that in addition to having “greater potential for recovery in recessions than high-yield bonds,” direct-lending strategies can serve as a “cushion against ultimately higher interest rates.” Orange County recently committed a collective $160 million to Monroe Capital, Crescent Capital Group, NXT Capital and Tennenbaum Capital Partners, four firms that have emerged on pension funds’ radar as direct lending has grown in popularity. Miller said that Orange County is considering increasing its allocation to the investment class (MML, 6/3).
Other funds have also carved out direct lending buckets recently. The $1.5 billion Stanislaus County Employees’ Retirement Association approved a 7.5% target allocation to direct lending at the end of last year, based on a recommendation from its consultant, Strategic Investment Solutions (SIS). Direct lending strategies offer “equity like returns with [the] risk profile of secured debt,” said SIS in its presentation to Stanislaus County’s retirement board. “High fees and a slight J-curve effect are mitigated by interest rates or coupon payments from underlying loans,” the firm added. In February, Stanislaus County gave the green light to three new investments with Raven Capital Management, Medley Capital and White Oak Global Advisors, allocating a total of $110 million to direct-lending strategies.
Despite historically low default rates and high recovery rates, direct lending does carry risks, particularly with liquidity. “These are fairly illiquid loans—you can’t trade them day to day,” Sheth said. “You need to lock up your money.” NEPC favors funds with five- to six-year life spans. Although there is large demand for direct middle-market loans right now, that could change if more capital flows into the market. “It’s more the market supply-demand imbalance that creates the opportunity, as opposed to the underlying manager skill set,” Sheth said. “If more capital comes in, the interest rate spread will come down and the relative attractiveness of the strategy will go away, which is why we prefer funds with shorter investment periods and lower fee structures.”
Some consultants, however, say that direct lending strategies don’t post sufficiently high returns to offset their illiquidity. “We don’t think that the return premium is big enough to justify locking up your money,” said Keith Berlin, senior v.p. and director of global fixed income and credit at Fund Evaluation Group. “If you’re going to be in a lockup fund, you want to have 300-500 basis points over comparable investments.”
Investors should also be cautious when choosing where to put their money, consultants say. Different managers target different segments of the market and not all of them stick to senior-secured loans. Strategies that put leverage on lower-middle-market loans or on lower parts of the capital structure can be riskier than those that focus on the middle- and upper-middle markets, said Sheth. “You have to be careful about what’s being marketed versus what’s actually the reality behind the investment thesis for each manager,” he added.
Article originally appeared in Money Management Intelligence. Link here (paywall).