Over the past few years, hoping for fixed income–like returns, investors have piled into private debt strategies. This shift has pushed inflows to new records. But asset raising has slowed in 2016, and some observers wonder if these funds can meet investor expectations with so much dry powder sitting on the sidelines.
New allocations to U.S. direct lending funds stand at $10.3 billion so far this year, according to data provider Preqin. That’s a big drop from the $15.4 billion gathered last year and the $19.7 billion raised in 2014. Inflows to other credit fund types, including mezzanine debt, special situations, and private debt funds of funds, are also down.
The only such U.S.-focused strategy to see an uptick is distressed debt, which hit $46.9 billion for the year as of November, topping the previous high of $39.5 billion at the end of 2015. That increase could be a signal that investors are hedging their exposure to other credit strategies that may begin to underperform.
“We think you could start to see more opportunities in distressed debt coming out of the middle market, where there has been a lot of lending,” says Mark Okada, co-founder and CIO of $15 billion credit manager Highland Capital Management. “Typically when you see as much activity in one part of the market as we have seen in the middle market, a distressed cycle follows.”
Okada adds that he’s been surprised by the surge of interest in private debt in recent years: “Anytime you’ve seen a segment expand the way private debt has — the size of this market rivals that of the CLO market — you have to start wondering about the real return potential.”
Okada, who started his career as a regional banker, notes that if the regulatory environment changes under president-elect Donald Trump, private debt strategies might face a double whammy of greater distress and new competition. “If the Trump administration rolls back some of the regulatory burden on regional banks, you could see them get interested in more types of lending again.”
So far, the incoming administration has been light on detail when it comes to policy, but Trump and his surrogates have been vocal about altering parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act that limit regional banking activities. Regional banks have had to respond to potential changes in how the current government classifies them by cutting back on lending.
Under the existing legislation, a bank can be declared systemically important once it has more than $50 billion in assets, even if that number is small relative to the size and reach of giants like Bank of America Corp. If Washington raises the threshold to account for the big banks only, smaller players could reenter the credit market, Okada reckons, creating new competition for private debt firms.
But others aren’t so sure. Michael Millette, managing partner at credit firm Hudson Structured Capital Management, argues that appetite for private debt has always been a part of the market: “Credit hedge funds, private debt funds, and BDCs [business development companies] can handle the demand for this type of lending without the same big-picture concerns regional banks have.”
Even with looser regulation, Millette thinks the market will only see an incremental increase in regional bank lending. If the Trump administration creates policies that are poorly executed or have unintended consequences, overall appetite for borrowing could shrink, he predicts.
One investor is inclined to agree. Zach Warren, head of corporate credit at $240 billion global asset manager Guggenheim Investments, contends that even if some regional banks return to the lending market, private credit has specific advantages over traditional banks.
“Our borrowers like the speed of private transactions and the certainty around underwriting and closing times, compared to a traditional bank, where you could be going back and forth for months,” Warren says, adding that private credit also has a somewhat symbiotic relationship with bank lending. “When banks overextend or don’t like the environment, they pull back from the market,” he explains. “So you could have a perfect borrower out there who can’t get financed because of a pullback. Private funds meet that demand.”
Existing regulatory changes, including the recent update to the Securities and Exchange Commission’s leveraged lending guidelines, have expanded the addressable market for investors like Warren. “There’s a temptation to say that the financial crisis and regulation caused banks to leave the market, but it’s not that simple,” he says. “That trade has been overstated. There’s an assumption that the equity market would tolerate more risk-taking at banks; it’s not clear to us that is true.”
Jonathan Bock, managing director at Wells Fargo Securities and an expert on business development companies and corporate lending, says the best thing for investors to do right now is temper expectations for both sides of the private debt trade. Bock doesn’t expect a wall of cash to come into the market from the banks, but he believes a shakeout is afoot for private debt funds and BDCs.
“Any Tom, Dick, or Harry can raise $100 million and say they are a great lender, but that’s going to be harder to prove in the next five years,” Bock says. “Just because there is a lot of dry powder doesn’t mean there aren’t opportunities, but investors will have to focus on the quality of who they lend with and lend to.”
Business development companies, for example, are lenders that are publicly traded but aren’t banks and act more like private debt funds. According to Bock, their stock performance is an indicator of the broader shakeout in nonbank credit. BDCs that have consistently overpromised and underdelivered are finding themselves exposed to the market.
“People talk about BDC performance because many of them trade above book value, but the well-run BDCs consistently trade at book,” Bock says. “This is true for business relationships in general. If you have a well-run business, you probably have a well-run loan book.”
Looking ahead, Bock sees the differentiation that took place among BDCs extending to other parts of the nonbank credit universe: “The asset class will continue to generate solid returns, but we are entering the part of the cycle where the subpar performers are going to be exposed.”