As the strength of the US economy continues to be of concern to some, investment advisors and institutional investors are investigating strategies which may be able to bolster portfolio performance. As confirmed in the June FOMC meeting, interest rates will remain at near-zero levels, a decision that while hoping to fuel domestic growth, could have allocators turning to the private debt asset class to counter continued low yield on fixed income assets. While direct lending does not have the long-term track record of various other alternative strategies, the medium-term results have demonstrated a favourable risk/return profile. Fundraising statistics tracked by Preqin show that investors are gaining interest and becoming more comfortable with the private debt space as a whole, most notably within direct lending.
According to Preqin’s Private Debt Online, the proportion of funds exceeding their target size increased by 7% between 2012 and 2013, and by an additional 2% the following year. Banks’ reduction in lending activity, brought on partly by new liquidity requirements, has left a space in the market for non-traditional lenders supported by consistent demand from SME borrowers in the US and European Union. Institutional investors have seemingly bought into the movement and seek to capitalize on the attractive returns available in the asset class.
Part of the appeal of non-bank lenders is their ability to cater loan terms to meet the specific needs and outlook of a corporate borrower more flexibly than could a traditional bank. A floating interest rate is one of many tools that a fund manager may use to hedge risk and maximize profitability. Since rates have been stagnant, floating interest rates may not be a concern in the short term, but will likely come into play over the extended life of most business loans.
As for the potential effects on the private debt market from an interest rate increase in 2016, it is likely that any retraction in fundraising would only be felt in the senior secured direct lending space. Banks slowly re-entering the lending space would be able to compete with senior debt managers, as the underlying borrowers in this segment would overlap with traditional bank loan recipients. Even then, experienced credit managers could have strengthened their reputation and place in the market, making it difficult for banks to recapture a share they once completely controlled.