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Direct lending funds offering superior risk/return profile

Preqin’s latest analysis of the risk/return profile of major private equity and private debt fund strategies has shown that direct lending funds have been providing investors with superior returns given their level of risk. 

These funds, which have increased in prominence since the fallout of the global financial crisis and the reduction in bank lending, are returning 11.4 per cent on average annually. This is only surpassed by distressed debt funds over the same period (vintage 2002-2012), which are returning 12.6 per cent. When looking at the disparity of returns, direct lending funds have one of the lowest standard deviations of 5.8 per cent, with only mezzanine funds providing a lower standard deviation of 5.3 per cent. 

Direct lending funds have provided investors with consistent returns for recent vintages. The median annual return between 2007 and 2012 ranges from 11.1 per cent to 11.6 per cent. 

Mezzanine funds of 2009 and 2010 vintage are providing investors with average returns of 9.0 per cent, but for the more recent vintages of 2011 and 2012, these funds are providing average returns of 13.2 per cent. Goldman Sachs also closed the second largest mezzanine fund ever in Q1 2015. 

With economic recovery taking hold across many nations worldwide, attractive opportunities for distressed investing are falling. Returns from distressed debt funds are 14.5 per cent on average for vintage 2009 and 2010 funds, whereas vintage 2011 and 2012 funds are providing returns of 9.4 per cent. 

Private debt managers put a lot of capital to work through 2014, with dry powder levels falling from USD179bn at the end of 2013 to USD139bn at the end of 2014. Levels have increased again to USD158bn as of the end of March 2015. 

Direct lending funds command the most spending power, with USD52bn in available dry powder. This compares to USD45bn for distressed debt fund managers and USD38bn for mezzanine opportunities. 

Notable Investors: Although still an emerging asset class, a number of investors have sizeable allocations to private debt. The Netherlands Development Finance Company, New York State Teachers’ Retirement System and California Public Employees’ Retirement System all have over USD5bn invested in private debt. 

“With historically low interest rates prevailing on government debt within many developed economies, and tight spreads existing on many types of tradable corporate and sovereign debt, investors are on a constant search for yield outside traditional fixed income products,” says Ryan Flanders, Head of Private Debt Products, Preqin. “Private debt within the US, and more recently Europe, has provided welcome opportunities for higher returns within the credit space. 

“The emergence of the private debt asset class has presented many attractive risk/return profiles for investors. The consistency of returns in direct lending is most obvious, with steady low double-digit returns and minimal standard deviation. As this is a small market relative to some other more defined alternative assets, the question is whether this can be maintained as the asset class becomes more crowded.” 

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