Private lending might not be yielding as much as it did immediately after the financial crisis,
but it is still attractive relative to many other asset classes. Emma Cusworth reports.
The heyday of private lending may already be gone. Despite the relative youth of the industry, yields have fallen in recent years as the funding vacuum created as banks withdrew from the lending market in the period immediately following the financial crisis has been filled by a plethora of new lenders. Institutions have poured money into new vehicles, further compressing returnsand increasing risk.
As some of the early adopters, who reaped the gains of moving in early, either withdraw or become a lot more selective about the loans they enter into, others believe the market remains attractive to further institutional investment, albeit with a more modest expectation of returns.
The private debt market has taken off in the post-crisis era as investors take advantage of the opportunity to generate yield in areas where banks have historically had a strangle- hold on the market.
CATCHING THE WORM
“The end of 2008 was a proper heart-attack moment for the banking system,” says William Nicoll, co-head of alternative credit at M&G Investments. “There were times during 2008 and 2009 where the lending market was extremely difficult for all companies. There was a point in 2009/2010 when lenders were rewarded just for having capital available, rather than for taking any risk.”
According to Kay Olschewski, portfolio manager, private assets at Unigestion: “There were a lot of good deals in the years immediately post crisis. Loan pricing adapted to higher default expectations and it wasn’t hard to get a 20% return, which is very attractive, but you had to have the guts to buy it.”
For some institutional investors, this created an opportunity for early birds to catch the proverbial worm by filling the void left by banks to clock up some strong gains.
The Church Commissioners for England (CCE) was among those early-adopters. Senior analyst Yodia Lo, says: “The vintage of private loans between 2008 and 2014 offered really attractive returns, especially for those willing to make European or European peripherals investments. There were a lot of companies with good businesses that needed money, but because the banks had left a vacuum in the lending market, they were getting financing at risk-priced levels. Today companies are not facing the same cash crunch or macro uncertainty so returns are less.”
RETURN COMPRESSION
As capital has rushed back into the market, the heady gains available at the dawn of the market have melted away. “Various funding sources have developed to fill the gap,” CCE’s Lo explains. “We have seen the evolution of many paths into private lending including peer-to-peer lending, asset managers launching vehicles, and hedge funds and private equity firms moving into the space. The market has become more competitive with more capital to deploy into a smaller opportunity set,” she says.
Preqin’s data shows 613 funds raised assets and closed between the start of 2010 and the end of the third quarter of this year, raising a total of $359bn.
Banks have also re-entered the fray to some extent, focusing predominantly on large companies and short-dated loans, but as the financial market environment settles, they continue to creep further back into lending. “They have come back to lending sequentially from large caps down and are also lending for longer than two or three years,” M&G’s Nicoll says.
The return of banks to lending has been more pronounced in the UK versus other European markets such as Germany, according to Unigestion’s Olschewski, who says: “If there is a stronger banking sector that limits the opportunities for private debt funds.”
Large companies in particular have found it easier to secure loans from more traditional sources as the financial sector has settled down post crisis, turning once again to banks or the capital markets. “Some of the companies we were lending to in 2009/2010 are now quite easily accessing bond markets for getting funding from banks,” says Nicoll.
Gone are the days of 20% returns in private debt, it seems. And, as banks continue to return to more normal levels of activity in the wake of the crisis and subsequent regulatory change, private debt faces a considerable drag on returns, especially given the continued low interest rate environment.
RISK ON THE RISE
With increased assets chasing loan opportunities, especially at the high-quality, large cap end, alternative loan providers are finding themselves looking for opportunities among smaller companies or those further down the credit spectrum. As they do so, risk increases. “The same returns are harder to find, especially given the continued low rate environment,” CCE’s Lo says.
“We are also seeing greater complexity or less liquidity in the opportunities that do arise.”
Unigestion’s Olschewski points to an increase in leverage ratios and the return of covenant-lite loans in “a big way”, which may be cause for concern. “Private debt is more risky than it used to be as there is a lot more supply,” he says.
Figures from Preqin show that investment into private debt has increased dramatically year-on-year. During the first three quarters of 2015 $64.5bn was raised globally by private debt funds, a near-40% increase on the same period in 2014.
Their data also shows the amount of dry powder (committed capital sitting in private debt vehicles that has yet to be invested) has increased markedly, reaching a record $191bn, up 37% since December 2014.
According to Preqin’s report, since 2008, the median proportion of capital called up during the first two years of investment is lower than pre-crisis levels. It points to the success of capital raising pushing up the level of committed capital faster than the number of deals available in the market.
This should raise two points of concern for investors. Firstly, some experts suggest the amount of capital now chasing deals, especially at the large-cap end of the market, is making investors less price-sensitive, raising the risk that some deals will be priced above fair value.
CCE’s Lo says: “Companies with large enterprise values or less leverage/unlevered have greater opportunity to access capital markets, creating competition for direct lenders and pressure on pricing. As well as the search for yield, there has been a flight to quality so people are willing to pay a higher premium for ‘safe’ deals. On the other hand, in recent markets the publicly-traded securities have shown how fragile that confidence in safety can be.”
Secondly, as the amount of dry powder increases as committed capital remains un-invested, it will take longer for investors to reap the rewards associated with allocating funds to the asset class.
“The sequence of returns is important for investors,” says John Belgrove, senior partner at Aon Hewitt. “Their ability to accept low returns in the early years has diminished.”
Both factors will compress returns further for investors going forward while the risk factors increase. CCE’s Lo says the fund,for one, may consider more selective opportunities going forward.
BUT 6% AIN’T BAD…
However, Coal Pension Trustee Services CIO, Stefan Dunatov, says: “Returns may have come down, but for the risk that is being taken, they are still pretty good.” Coal Pension Trustee Services has expected returns for its specific portfolio in the 6% to 8% range.
“We have not found ourselves competing with banks, although this depends on the mandate,” he continues. “They are still going through a period where they are lending relatively little and are still in a period of consolidation in Europe, which will keep the asset class interesting for investors.”
Europe is considerably behind the US when it comes to the maturity of private debt markets and M&G’s Nicoll sees the further development of the European private debt market as an “on-going evolution” of capital markets. He believes the further development of the private debt market has a long way to go and is an important part of a “healthy market” in which banks no longer have a stranglehold on the loan market.
Preqin’s data shows Europe is the top focus for investors in private debt. Its report showed 73% of investors were targeting Europe in the next 12 months, followed by the US with 68%.
Banks also continue to struggle with lending in the very long term, over 40-years for example, and some argue institutional investors, whose time horizon is a more natural match to long-term lending have an important role to play in funding projects such as social housing.
And there are signs that returns could be back on an upwards march having cratered during the summer this year. Unigestion’s Olschewski points to the S&P LSTA leveraged loan index as a good yardstick for where private debt pricing should be.
During the 10 years to 12 November 2015, the S&P LSTA index has posted annualised returns of 4.37%. Year-to-date the index return was up 1.27%, but was still down 1.22% on the return achieved in 2014.
“It looks like the market has been bottoming out since the summer,” Olschewski continues. “In the early summer it was around 5%, but it is now back up at 6.2%. If you don’t get that, plus about 2%, then it doesn’t make sense to go private as you’re not getting the illiquidity premium.”
In a world starved of yield, the returns offered by private debt may well still look attractive relative to other asset classes even if they don’t match those on offer in its early years. Investors will have to work harder to ensure they are not compromising too much as risk, complexity and illiquidity are on the increase in a world struggling to allocate all the capital that has already been committed to the space.
Seeking out the best opportunities in the asset class will be more tricky, but with 6% plus on offer, as Olschewski says: “Most investors would take that in a heartbeat.”
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