Closed-end private debt funds typically have their capital commitments locked up between five and 10 years. With these fund terms, investors demand higher returns relative to general fixed income vehicles to compensate for the illiquid nature of these investments. As a result, managers orient their strategies to produce superior returns necessary to cover the marginal return to investors. Historically, as shown in the chart below, direct lending vehicles have produced returns ranging from 11.55% to 15.35%. However, with the inevitability of rising interest rates, and institutional investors’ capital locked up for the medium term, it remains uncertain that the favourable credit conditions experienced today will last throughout the terms of these private debt vehicles.
In 2014, private debt fund managers generated higher returns for investors with high-quality alternative lending deals, as opposed to banks, whose business centres on deal volume and the resulting fees. Going forward, to remain competitive with banks in the lending environment, fund managers will need to place a stronger significance on pricing risk, given the expected changing market conditions. When rates rise, managers must focus on appropriately pricing the creditworthiness of borrowers and their ability to pay back loans and interest. Fund managers will need to remain selective with their deals and focus on high-quality lending opportunities. As the capital raised is locked up for the intermediate term, there is more time for a manager to put capital to work in a more discerning manner than banks and traditional lenders, which do not have access to long-term capital commitments at the same level. This allows more time for private debt fund managers to pursue strategies that banks and other lenders may not be able to.
Private debt fund managers will need to continue to provide an illiquidity premium in order to remain competitive in the higher interest rate environment expected ahead. While banks continue to participate in syndicated loan deals, how will private fund managers build in marginal yield in order to remain competitive in a higher interest rate alternative lending environment?