Stockholm (Ekonamik) – Investors have intensified the search for uncorrelated returns and have increasingly turned their attention to the alternatives space. The private lending market – which spans leveraged loans and private debt – represents one slice of the broader alternatives universe.
The private lending market has grown considerably since the financial crisis as traditional banks have been cutting back on business lending. At the same time, institutional interest in the market continues to grow in the age of diminished return expectations for other asset classes. Some worry too much capital is chasing too few deals, and this article will highlight some concerns, thoughts and insights from industry professionals on this fast-expanding asset class.
The Emergence of the Private Debt Market
Whereas the private debt market is increasingly becoming a more diverse asset class, Supriya Menon and Andrew Cole from Pictet Asset Management view the private lending market as “broadly made up of leveraged loans and private credit, with the latter pool including investments from collateralised loan obligations (CLOs) and senior loan funds.”
According to Nicole Downer, Managing Partner at European credit specialist MV Credit, the main macro change since the last recession “has been the move in the leveraged loan and private debt markets from a predominantly bank underwritten market to more direct relationships between non-bank lenders and the ultimate borrowers.” As traditional lenders have gradually retreated from business lending post-Lehman due to increased regulation, the private lending market has boomed. “Over the last few years, changes in regulation have led to banks retrenching from various parts of the market,” said Downer.
In its 2019 Global Alternatives Outlook, J.P. Morgan Asset Management echoed Downer’s thoughts. “Banks and life insurance companies dominated private credit until regulations born of the global financial crisis (GFC) led them to dramatically pull back. Increasingly, fund managers have stepped into this void.”
Benefits and Risks
Institutional investors have always relied on traditional asset classes to meet their investment return needs, but yields across most asset classes have dropped significantly in recent years. According to Supriya Menon and Andrew Cole, “on the face of it, the private lending market has a lot to offer institutional investors in a world of near-zero interest rates.” The duo further wrote that “returns on leveraged loans and private debt are relatively high – in part to compensate investors for the assets being relatively illiquid – while volatility is lower than for high yield bonds.” The high coupons on offer are appealing to pension funds and other institutional investors as they enable this pool of investors to meet ongoing obligations.
According to the Direct Lending team at Hermes Investment Management, “currently, investor demand is being driven by the search for yield in a low-rate environment.” However, the Hermes Direct Lending team reckons that direct lending, a term often used interchangeably with private lending and private credit, “offers many other attributes that make it attractive to investors.” The team highlights the high potential risk-adjusted returns, illiquidity premium, floating rate yield and low volatility as other appealing attributes for investing in private credit. Barry Fricke from Aberdeen Standard Investments agrees, saying that “opportunities for investing in private credit have expanded dramatically in the last ten years,” thereby “providing investors who are able to sacrifice some liquidity with access to higher yields, an improved risk profile and exposure to less correlated economic drivers.”
Increasing Concerns Over Leveraged Loans
Leveraged loans are loans issued to highly indebted companies, most of which are repackaged into collateralised loan obligations – legal entities managed by private equity firms, hedge funds and other players. As a subset of the broader private lending market, the leveraged loans market has exploded since the financial crisis. Andrew Wilmont and Supriya Menon from Pictet Asset Management, however, are warning that “conditions in the booming leveraged loans market look worrying.” They are not alone; there is a rising chorus of voices warning about the current state of the leveraged loans market.
“As issuance of leveraged loans has risen rapidly, covenants that protect investors have weakened, credit quality has deteriorated and the market’s ability to withstand stress in its current form remains largely untested,” wrote the duo from Pictet Asset Management in March. “All the ingredients are there within this sector of the market for there to be meaningful problems when the economic slowdown does occur,” Dan Ivascyn, chief investment officer for Pimco, was quoted by the Financial Times at the beginning of the year.
The list of voices speaking up about the risks prevalent in the leveraged loans market has been steadily growing. “It’ll be ugly for those companies if the economy slows down and they can’t carry the debt and then restructure it, and then the usual carnage goes on,’’ said Bank of America’s Chief Executive Officer, Brian Moynihan, in an appearance at the Economic Club of New York. “We don’t see anything yet because the economy’s good, the companies are making money,” he added. Janet Yellen, the former chair of the Federal Reserve, issued a similar warning last year, saying that “if we have a downturn in the economy, there are a lot of firms that will go bankrupt, I think, because of this debt. It would probably worsen a downturn.”
Indeed, widespread investor demand for leveraged loans and businesses willing to take on more debt has resulted in a deterioration in lending standards. However, some believe that the concerns over the state of the leveraged loans market are overblown. “The main point is if a manager is bad at credit underwriting, the existence of covenants alone won’t protect you from bad credit risks and eventual realised losses — credit selection is the most important factor,” Keith Ashton from Ares Management was quoted in a Financial Times article.
The Leveraged Finance Fund management desk at M&G Investments agrees, saying that “leveraged lending is a highly analytical decision, made by an experienced credit manager, to make a loan to a sub-investment grade company – often one that is large, well-known, global – with visible cashflows and measurable presence.” While acknowledging that “higher corporate leverage and looser lending standards are not to be taken lightly,” the team at M&G argues that “in the loan market, lenders undertake extensive due diligence on individual borrowers and their loan documentation before deciding to lend.”