Monday, July 24, 2017

Direct Lending Funds' Fading All-Weather Appeal

By Lawrence Delevingne
Reuters
July 24, 2017

Miami-area money manager Bob Press appears to offer the ultimate all-weather investment: a "direct lending" hedge fund that does not require a long-term commitment and has produced nearly 90 straight months of positive returns not correlated to other markets.

Most funds invest in traditional financial assets like stocks or bonds, but direct lenders make high-interest rate loans, usually to fledgling or struggling businesses passed over by banks. Proponents say the strategy can produce smooth returns even in a low-growth economic environment.

But as money pours into offerings like Press's TCA Global Credit Master Fund, there are mounting signs that such steady returns may be at risk.

More than 30 investment professionals canvassed by Reuters list various reasons for concern: the flood of new money pushing down lending standards, an increase in leverage and, sometimes, a mismatch between the duration of investments and lock-up periods.

A November survey by data tracker Preqin showed nearly 40 percent of direct lenders believe loan terms had become easier compared with a year earlier and nearly a third said it was harder to find attractive borrowers.

Returns are also starting to decline into the single digits, according to data trackers. (Graphic: tmsnrt.rs/2toxFGl)

Some of those investors have just grown more cautions and selective in their fund choices. However a small but growing group of those who embraced direct lending after the 2007-2009 financial crisis said they are now significantly reducing their exposure or avoiding direct lending investments entirely.

The rising risks, they told Reuters, could lead to much lower returns, or even a partial repeat of 2008, when a group of funds lost money and froze investor capital as borrowers failed to repay their loans and collateral seized up.

Those who have pulled back include $1.4 billion Balter Capital Management LLC, which included direct lending as one of its top three strategies a few years ago and now has no money in it, according to founder Brad Balter. Greycourt & Co. has significantly reduced its exposure to direct lending because the money coming in has made it far less attractive, according to Matthew Litwin, head of manager research at the $10 billion firm.

"With a few exceptions, it's more risk for less return," Litwin said.

Untested


Direct lending surged after the financial crisis when U.S. authorities tightened credit standards for banks and ultra-low interest rates drove investors to less conventional strategies in the search for higher returns. According to Preqin, U.S. direct lending funds soared from about $33 billion in late 2008 to around $100 billion in June 2016.

The strategy remains popular as high stock valuations and historically low bond yields have boosted demand for private debt strategies. A Preqin survey of 100 institutional investors in January showed that 58 percent expected to increase allocations to U.S. lower-middle-market direct lending in the next 12 to 24 months.

However, several lenders and their investors told Reuters that the strategy's ability to deliver in tougher times has not been tested for years given relatively steady economic growth.

They say the flood of cash itself is driving down the returns and eroding lending standards by giving borrowers more options. The rising demand has spawned a slew of new funds, they add, that may lack experience with loan workouts in recessions and rely on deals sponsored by private equity firms, which tend to come with higher leverage and lower yields than those originated directly.

"There's a lot of Johnny-come-latelies given all the new money. The inexperience hasn’t really shown yet, but it will,” said Mark Berman of MB Family Advisors, LLC, another fund investor who specializes in credit strategies.

Nearly 200 North American direct lending funds have launched since 2009, according to Preqin, compared to just 30 between 2004 and 2008.

Investment professionals interviewed by Reuters say lenders are more likely to do “covenant light” deals with fewer restrictions on the terms of the loan, or deals where they were not necessarily first in line to receive payments in the case of default.

Rising leverage is another red flag, a sign that both investors and target companies are trying to stem a decline in returns by borrowing more.

Thomson Reuters data on unregulated non-bank loan deals show leverage for middle market companies has risen by 16.6 percent over four years to an average debt-to-earnings ratio of 4.9 times.

TCA's Press acknowledges double-digit returns could be a thing of the past. The 53-year-old sees risks to the strategy as more money comes in, but notes TCA does not use leverage and sources all of its own deals.

Press expects his business - situated next to a golf course in Aventura, Florida - will keep growing, given that banks remain reluctant to lend, allowing him to take profits on both loans and advisory fees. TCA started with a few million dollars under management in 2010 has grown to roughly $500 million and aims to raise another $300 million.

Quick Cash


A promise of fast access to cash has helped smaller firms like TCA and Brevet Capital Management grow rapidly.

Larger managers, such as Golub Capital, Czech Asset Management LP and Monroe Capital LLC, require investors to commit their capital for three years or more.

But about two-thirds of funds have lock-up periods of a year or less, including none at all, according to an eVestment review of 71 direct lending and asset-based lending funds for Reuters.

Those who offer generous cash-out provisions say the short duration of the loans and their diversity mitigate risks, and provisions that allow them to freeze funds are disclosed to clients.

"We work very hard to prevent mismatch and make sure that our loans line up with what we’ve promised investors," said Brevet founder Douglas Monticciolo.

TCA's Press said there was an inherent asset and liability mismatch in open-ended funds, even if the loans are short term. “You can’t make it go away. You minimize it the best you can,” he said.

Those who warn of increased risks often recall the 2008 financial crisis, when a combination of loose liquidity, high leverage and quickly-soured loans hurt direct lending firms such as Plainfield Asset Management LLC and Windmill Management LLC's SageCrest.

Plainfield, a $5 billion-plus firm in Greenwich, Connecticut, ended up liquidating its portfolio and shutting down following heavy client redemptions and loan restructurings, even though it reduced leverage before the crisis. Investors ultimately got $0.60 for every dollar invested, according to HFMWeek.

Plainfield founder Max Holmes told Reuters that direct lenders today could be similarly exposed whenever the next downturn comes, especially those with insufficient capital lock-ups. "We have all the same symptoms," he said, citing the loosening of lending standards and high leverage.

A former attorney for SageCrest, which went bankrupt in 2008, did not respond to a request for comment.

The similarities make some experienced investors urge caution even as money keeps flowing in and the economy continues to grow.

"We are ever more cautious about the returns direct lending is going to generate," said Chris Redmond, global head of credit at investment consultant Willis Towers Watson and an early proponent of the strategy. "The risks are starting to add up."


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