Funds providing loans to private companies have proven to be very popular among investors over the past decade. But some recipients now fear that strong asset growth and an uncertain economic environment will weigh on returns.
The private debt sector has been one of the most favored alternative asset classes since the financial crisis, growing from less than $400 billion in assets at the end of 2008 to around $1.2 billion at the late last year, according to data group Preqin. .
Its seemingly reliable and consistent returns have attracted yield-hungry investors during an extended period of rock-bottom interest rates.
But some are now wondering whether funds are struggling to find suitable places to invest all the capital they have raised and, when they do invest, whether margins are lower and covenants looser.
“People should worry about the amount of capital in the private space, both invested and the amount of dry powder [unallocated capital] looking for investment goals,” says Jim Neumann, Chief Investment Officer at Sussex Partners, which advises clients on alternative investments.
“We’re not advising clients to do much more in private credit at this stage of the market, because there’s a shoe to drop there.”
This so-called dry powder has accumulated during the coronavirus pandemic, according to Preqin. Many investors committed capital in 2020 in anticipation that Covid-19 would create a wave of struggling opportunities. But, instead, they found that huge levels of government support for businesses limited those opportunities, leaving more capital unallocated.
Total dry powder in the sector stood at a record $405.4 billion in March this year, up from $118.4 billion at the end of 2011. However, the amount of capital committed but unallocated as a proportion of total sector assets was higher. ten years ago than last year.
Some in the industry say that the fact that the share of dry powder in total assets has not increased shows that the sector still has plenty of room to grow.
“My reaction, when I hear that ‘so much money has been invested’ [to the private debt sector]is that this market did not exist before 2008 or 2009 in Europe,” says Kirsten Bode, co-head of pan-European private debt at investment firm Muzinich & Co.
“Dry powder has been pretty consistent – volume has increased, but in line with assets under management,” she says. There was “no reason”, she adds, for the sector not to be as big as the private equity sector, which has about $5 billion in assets according to Preqin.
Private debt – a sector that includes direct lending, as well as distressed debt and mezzanine debt – has risen to prominence by filling the void left by banks as they cut riskier lending to small and medium-sized businesses. businesses.
For borrowers, a loan from a direct loan fund may be more attractive than a syndicated loan because of the relative simplicity of negotiating with one or more of these funds. The money is also accessible more quickly, although the interest rate charged may be higher.
For lenders, however, there are signs that the weight of the money invested has lowered protections in some areas of the market by reducing or loosening covenants – even though most deals still have at least one covenant. restrictive, according to S&P Global.
“The upper end of the middle market,” where the largest direct lenders operate, “became very competitive, and they had to make concessions on margins and covenants to get deals done,” says Andrew McCaffery, global director investments. manager at Fidelity International. Still, he thinks middle-market business loans are still attractive.
Yields have also trended lower, with the rolling three-year internal rate of return falling from 8.5% in 2015 to 5% in 2020, according to Preqin.
Some investors are already abstaining. Michele Gesualdi, founder of London-based investment firm Infinity Investment Partners, for example, says he invests “very little” in the sector because it is “very asymmetric” given the “low yield[s]on offer versus risk.
And, as the global economy enters an era of high inflation and rising interest rates, with Russia’s invasion of Ukraine threatening economic growth while adding to inflationary pressure, some see this risk increase.
Floating rate loans linked to rising borrowing costs may offer investors some protection on real returns, but inflation and rising funding costs threaten the creditworthiness of some borrowers struggling with rising costs inputs. If high oil prices and sanctions against Russia lead to a sharp contraction in the global economy, this could put pressure on the sector.
Fidelity’s McCaffery suggests the sector will be “better insulated than many other asset classes” from the impact of inflation and growth shocks. But his firm has analyzed companies’ ability to absorb higher prices and the impact of any decline in economic demand, he adds.
“The resulting inflationary pressures [from the war in Ukraine] — and the impact this has on consumer demand and growth — is likely to affect borrowers in all markets,” he says.