As Europe’s private debt market continues to evolve, those managers well placed to offer direct lending strategies could benefit substantially as insurance companies, in particular, seek alternative yield-enhancing funds within their credit portfolios. Not only do direct lending strategies provide stable, consistent returns over a multi-year time horizon, they also allow insurers to make more efficient use of their Solvency Capital Ratio (SCR) under Solvency II regulation.
The capital charge is estimated to be 20 per cent. Factor in that these are private closed-ended investments, offering insulation from market volatility, and suddenly one begins to understand why direct lending is becoming such an attractive asset class.
According to figures produced by Preqin, a total of 83 private debt funds have launched over the first three quarters of 2015, representing an aggregate AUM of USD64.5 billion.
The third quarter saw the same number of fund launches (27) as compared to Q2, and whilst North America led the way in terms of the highest number of new funds – 14 compared to 8 in Europe – European funds secured a higher volume of net asset: USD10.3 billion compared to USD7.9 billion.
“This growth in Europe has been particularly driven by direct lending funds, as four funds have closed in the quarter, raising USD6.7 billion,” says Ryan Flanders (pictured), Head of Private Debt Products, Preqin. “The strategy has become increasingly popular in developed markets, as companies look to secure funding from non-bank lenders. With restrictions on bank lending remaining, and liquidity and issue for many companies, the direct lending market in Europe and other regions has more room yet to grow.”
Intermediate Capital Group are certainly at the forefront of this growth. The group launched two significant funds in Q3: Senior Debt Partners II, a USD3.4 billion direct lending fund, and ICG Europe Fund VI, a USD3.3 billion mezzanine fund.
Ardian also launched a substantial direct lending fund – the USD2.2 billion AXA Private Debt III – last quarter.
Within the private debt space there is particular interest among investors for direct lending funds.
Of the USD19.3 billion in assets raised by private debt funds in Q3, direct lending funds accounted for USD9 billion of those assets. They also accounted for 11 of the 27 new fund launches in Q3.
The growth trajectory in private debt is likely to head ever higher as regulation such as Dodd-Frank and Basel III clip the wings of banks and force them to build stronger balance sheets. Such is the scale of pullback in traditional loan activities that an estimated USD1.3trillion of assets are likely to be lost to alternative asset managers over the coming years according to Goldman Sachs.
If that estimate is even close to being borne out, that represents a massive opportunity for fund managers in the US and Europe. Granted, only the very largest hedge funds can hope to compete with seasoned players such as ICG, Ares Management and Cerberus Capital Management – all of which feature in Preqin’s list of top 10 largest private debt funds. But any manager able to demonstrate an attractive investment proposal should stand to benefit, even if they are targeting more modest assets of USD200 – USD300million.
“There can be any number of factors that investors look at when considering hedge funds – strategy, performance, volatility, fees and terms, the relationship they have with the manager. Preqin’s most recent survey of hedge fund managers showed that the majority feel they differentiate themselves by their strategy, while others felt transparency, investor relations, or managers’ ‘skin in the game’ was what made them stand out. Only 23 per cent of investors, meanwhile, said that they had rejected committing to a hedge fund simply because it was too small. There is clearly a lot of room for hedge funds of all sizes to attract investors, as each investor is looking for different things,” comments Flanders.
At a time when asset raising is so challenging, second generation managers who are preparing to spin out and set up their own funds would do well to target this burgeoning area of the hedge fund firmament.
Preqin’s figures reveal that overall there were 224 private debt funds in the market at the start of Q4, targeting USD117 billion in aggregate capital. Of that number, 116 are North American-focused funds. Again, this is unsurprising. Europe is still behind the curve in terms of the institutionalisation of its capital markets, but as banks scale back, the depth of breadth of its private debt market will grow. Currently, they account for 67 of the 224 funds, targeting USD37.4 billion.
Over half of private debt funds (57 per cent) are direct lending and distressed debt funds. This is set to increase as we head into 2016. As Preqin’s research reveals, 68 per cent of LPs plan to target direct lending funds over the coming 12 months and as such is expected to be the go-to strategy in private debt.
“There are signs that the rapid growth seen in the private industry over the past two years will not continue at the same pace,” warns Flanders. “While global fundraising totals for 2015 look set to beat 2014’s USD75.7 billion total, they do not seem likely to vastly outstrip it. Similarly, the number of funds in market at the start of each quarter has remained steady in recent periods, as have their total capital targets.
“However, the rising popularity of the asset class amongst investors, and the continued slump in commercial lending, mean that private debt looks likely to continue to grow at a steady pace in the medium term. Upcoming legislation is more likely to help than hinder; in particular Basel III, which will dictate levels of leverage available to banks, may provide an opportunity for private debt firms to fill the gap left by more traditional lenders.”