Direct Lending Unlikely To Deliver Promised Returns
Endowment and pension fund investors were promised 8-12% IRRs from direct lending funds (by the people selling them) so they duly committed well over $400 billion to direct lending (DL) funds over the last 5 years, double the amount of the prior 5 years. But direct lending LP's should lower their expectations for actual realized returns from these funds for two major reasons -- both the result of the huge jump in commitments.
Direct lending funds, desperate to invest all the money they raised, are taking more credit risk, accepting worst terms, at lower yields
First, unlike private equity, DL managers compete with a number of other types of credit - - most particularly, syndicated bank loans (BSLs). And the banks are not rolling over and letting direct lenders take the market. They're competing fiercely to provide financing for buyout deals - - the bread and butter of direct lending -- and some are getting into the direct lending business themselves.
We can see the effects of this in the chart below which shows the difference between the spreads on DL versus BSL deals narrowing by about 100 bps over the past year.
We can also see it in the rebound in the volume of BSL deals (aka "institutional leveraged loans") financing PE buyouts compared to DL in Q1 this year.
Direct lenders complain merger activity hasn't rebounded as they expected, but M&A Volume for North America has been running at over $400 billion a quarter for the last five quarters, only slightly below the levels in the years prior to the 2021-22 surge.
More from Bloomberg:
[Bloomberg] With dealmaking still lackluster and the broadly syndicated loan market returning to life, competition in the burgeoning $1.7 trillion private credit market is forcing funds to adapt to a much harsher environment... Putting exact numbers on spreads on private loans is imperfect at best, and deals vary widely. Overall though, on a like-for-like basis spreads have shrunk about 100 basis points since last year, according to dealmakers who asked not to be identified discussing confidential information.
The heightened competition for deals has another negative effect - - it drives direct lending GPs desperate to put money to work to lend to weaker credits with worse terms and fewer covenants.
From Bloomberg:
Private credit funds are also going after more junior pieces of the capital stack. This debt gets paid back after the senior lenders, but in exchange reaps more money. Payment-in-kind debt, where the borrower pays interest with more debt, is even riskier... Marc Chowrimootoo, portfolio manager and managing director at Hayfin Capital Management, expects high PIK issuance to continue into next year as private equity firms use borrow-now, pay-later arrangements to keep cash-pay leverage low while central bank rates are still high.
So direct lending GPs with aging commitments burning a hole in their pockets are accepting lower spreads and/or making loans to weaker credits or with worse terms. In other words, lower returns and/or greater risk then what LPs thought they were getting.
For any opportunity, if the amount of capital to be invested grows rapidly while the size of the opportunity set grows much slower, all else being equal, returns will come down. That sounds obvious but in my experience, it is almost never discussed or considered by endowment investors. While one can never be precise about such things, clearly if you double the size of dollars to be invested, as has been the case with direct lending, absent a surge in the size of the opportunity set, it's going to affect the economics.
In February 2022, I wrote about how the astonishing growth in private equity fundraising was one of a number of factors that would contribute to declining excess returns versus public equity, because the opportunity set for PE funds, contrary to what they will tell you, is finite and thoroughly picked over. Pardon me for patting myself on the back but so far, things are playing out very much as I predicted in this piece:
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You Won't Get 12% If You're Sitting in Cash
The second reason return expectations should be moderated, is very simple -- and hence usually overlooked. Direct lending funds are taking longer to invest commitments. Almost 1/3 of private credit dry powder is from funds over 2 years old ("private credit" includes various types of credit funds including direct lending, distressed debt, real estate debt, etc. Direct lending makes up close to half of private credit). Obviously if it takes your manager a year or more to actually invest the commitment you made, the time you're not invested and are just sitting in T-Bills has to be considered part of your all-in realized returns.
To illustrate, let's look at investing in a private DL fund with a conventional drawdown structure versus an institutional BSL loan fund.
Historically, bank loan funds have returned about a percent or so less then direct lending funds. Single B-rated bank loans yield only a percent or so less than DL loans as we saw above. The interest payments for BSL are structured as a spread over cash rates, just as they are for direct lending; and the funds raised are used for similar purposes (to finance LBOs). As a result, BSL funds have similar duration and credit characteristics as direct lending funds, only the BSL credits tend to be larger and somewhat better quality. In other words, on a quality adjusted basis, bank loans returns have been a bit below that of direct lending funds. This isn't surprising as they are essentially investing in the same thing.
The total size of the BSL market is about 1.4 trillion, with about 2/3 of that ending up in CLO funds, and several hundred billion in institutional and retail bank loan funds. In other words, this is a big liquid market that all but the biggest investors can go into and out of with relative ease.
As a result then, it would be relatively easy for many institutional investors to be close to 100% invested, close to 100% of the time relative to their target allocation by simply investing in bank loan funds. With a DL fund commitment, the investor will probably never be 100% invested (relative to target) and in the first year might be 50% uninvested. The timing is entirely in the hands of the GP.
For very large institutions with a number of DL funds, this may not be an issue -- they have capital calls and distributions coming in from multiple funds and so they can maintain a fairly constant allocation. But for a mid-sized endowment with just one or two direct lending funds, a good portion of their commitments will be sitting in cash for significant periods of time. The actual realized returns for such funds -- for the investor -- will be substantially less than the funds' stated IRR.
More from Bloomberg:
Dry powder, or the amount of money committed to private credit funds that has yet to be deployed, is at a record. That’s in part because demand for their capital from buyout firms remains tepid. What’s more, bank leveraged finance desks are increasingly seeking to poach back business. The result has been what some have called a ‘race to the bottom’ among private credit managers... “Because of this supply-demand imbalance you’re starting to see this behavior shift in parts of the private credit market — turning into a bit of an auction for the tightest terms,” said Sachin Khajuria, who runs family office firm Achilles Management and invests across private assets. “That means weaker underwriting standards due to competition.”
“Right now I’d be really selective in private credit,” said Khajuria, a former partner at Apollo Global Management Inc.
Credit is a very different animal then equities -- which I think many investors have overlooked given that bonds have been an afterthought for most of the last 15 years. With equities, you're investing for growth -- you have 100% downside but maybe 5x upside. Credit is the reverse. It's a yield game. You need to remain invested, you need to clip coupons -- you need to bank that yield because that yield is most of your return. You have 100% downside but only 50% upside depending on how crappy the credit is, and you can't afford to piss away returns by being uninvested or under-invested relative to your target or you'll never come close to achieving your target return for your target allocation.
So, given all of this, what on earth are CIOs doing investing in credit in a drawdown structure? At a minimum, institutions should consider funding capital calls out of a bank loan ETF position dollar for dollar, to make sure they remain fully invested. If not, this investment simply doesn't make sense. The potential returns would have to be a good deal higher to offset all the times you're not invested.
What hasn't changed: Same high fees, terrible liquidity, higher risk, more resource intensive.
What's not to like?
Finally, as I have discussed in a number of previous posts, in addition to the likelihood of a reduced return premium for private direct lending funds versus publicly listed bank loan funds, there's many other reasons to prefer bank loan ETFs to private credit. DL funds have terrible liquidity, are far more expensive, require far more resources to do manager diligence and monitoring (investment, legal, and operational), have vastly greater dispersion risk (i.e., your manager turns out to be fourth quartile and you make 2% instead of 12%), have lower overall credit quality, and potentially have far more specific credit risk (because a DL fund will make ~ 20-100 loans whereas a BSL fund is likely to have 100 to 500 individual credits so can be seen as a sort of BSL index fund).
If it is indeed the case that average returns for direct lending, properly evaluated, will not be much above syndicated bank loan funds, and you then consider all the other negatives, for all but the largest most sophisticated institutional investors it begs the question: why invest anything in direct lending funds?
Invest with impact and pay it forward.
9 个月It feels like there is a wall of money in idle hands, which usualy does not bode well for logical risk/reward decision making. Private equity and direct lending still benefit from “managed” valuations when they compare with marked to market strategies/products… not marking assets needs to be recognised as a risk (increased binarity of valuation outcomes, especially if investors cannot access decent secondaries markets) and not as the wrongly popularised perception of lower volatility. Interest rates were more volatile and significantly higher than the last decade or two, which by the way were not the new normal. As much as people wish it, ZIRP and NIRP are symptomatic of extremely ailing economic conditions and a last ditch Hail Mary to keep the consumer alive. The only real scenario for such rate conditions to return, especially with an increasingly polarised and challenging procurement supply chain (read cost pressures all around) is not because problems have been solved, but rather if we enter a depression, in which case DL and similarly illiquid PE buckets, well they will need to be held by someone…
Co-Founder of EnnisKnupp, Former Editor of Financial Analysts Journal, Author
9 个月Excellent. Thanks.