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Will nothing quench direct lending thirst?

15 January 2018
Charlie Corbett

Despite record volumes and enough dry powder to blow up a medium-sized parliament, the market for direct lending appears to have plenty more capacity to soak up record-breaking demand

The first rule of investment: when your taxi driver or the pub bore starts dolling out free investment advice on a particular company, product or market – bolt for the hills. Do the exact opposite of what he says. Why? Because that market is about to explode. It’s an old rule, but a sound one.

It happened to me this summer in connection with direct lending. I was minding my own business in the beer garden of my local pub, when I was approached by our very own self-appointed village oracle. A man with the look and feel of ex-Tory chancellor Ken Clarke but the political disposition of Nigel Farage. He tapped his mottled, burgundy-tinted nose and said to me conspiratorially: “direct loans, old fruit. That’s where we should be investing. It’s an easy 8% for barely any risk. A no brainer.”
This comment got me worrying like never before about direct lending.

Toppy times

I am categorically not saying this market is about to explode. But it is looking rather toppy. In fact even some of the sector’s most high-profile investors are predicting some kind of correction soon – as I found out at our Alt. lending event New York in July.

I won’t bore you with the statistics. You will have heard them all before. Though one number does stand out above the rest: According to Alternative Credit Council forecasts, based on its current growth rate, the sector will reach $1 trillion in assets by the end of the decade. Wow. Now that is a BIG number. The market has already grown by 14 times since 2002 to reach $600bn in assets today. I mean, really, what next for direct lending?

It’s a far cry from 2008. Back then direct lenders filled a mid-market gap created by the retreat of the once mighty banks, humbled and hobbled by the financial crisis. Direct lenders took on the mantle of providing much-needed credit to SMEs who had been deserted by the more established names. These days funds have grown so large they are competing directly with the big banks on billion-dollar deals for multinational companies. Not to mention their weighty contribution to the private-equity sponsored buy-out market.

Risk appetite grows

The inexorable rise of the direct lender began in the US, and has since spread to Europe. Data provider Preqin estimates European-focused direct lending funds raised around $50bn from 2013 to 2016. And some individual deals have now surpassed €600m in size. Deal flow was up 6% in Europe in the first two quarters of 2017.
In a world starved of yield it has been seen as a market that offers a healthy return for relatively low risk (the village oracle is right about that). But the big question is: has the market now outgrown itself? Could it be that as more and more players have entered the market, returns have diminished, deal sizes got too high, and risk appetite soared to dangerous levels?

According to Preqin, there is now $74bn swilling about in the system and available to invest from direct lending funds (after a record year of fundraising in 2017). Where is it all going to go? Have we reached peak direct lending? The answer to this question, according a November report from Preqin, is no, not yet. It says the market is plenty big enough to soak up this extraordinary demand, and estimates that in the sponsored private equity market alone there is a lending capacity of $400bn. Add refinancings to the pot and that number bumps up to $600bn. Plenty of capacity, then, to soak up a meagre $74bn.

“Any concerns about an overheated lending fund environment appear to be unfounded, even as fundraising and dry powder set new record highs,” Preqin says. “There is space for growing demand to be fulfilled by quality private debt opportunities.” So there you go. Maybe on this occasion the pub bore could be right? As always, I have my doubts.

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