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Risk/Return Profile of the Direct Lending Strategy – A Comparison of Debt Strategies - January 2015

by Thomas Mulready

  • 19 Jan 2015
  • PD

Direct lending as a strategy is set to continue attracting significant investment capital and resources moving into 2015. Preqin’s Private Debt Online service shows that direct lending funds make up the highest proportion of private debt funds currently in market. In light of this, how does the risk/return profile of the strategy compare to other, more established debt strategies such as mezzanine or distressed debt? 

When considering new investments, one of the main factors any investor will take into account is the potential yield a particular strategy can offer. However, the potential yield needs to be considered in the context of risk. Do the returns on offer make the risk worthwhile relative to other investment options?

The chart below represents the risk/return profile for the main private equity and private debt fund types over a 10-year time horizon. The chart includes direct lending, inclusive of senior, junior and unitranche debt structures; it also includes distressed debt and mezzanine strategies separately. The levels of risk and return are represented by the standard deviation of the net IRR and the median net IRR respectively, with the size of each sphere representing the size of each strategy in terms of total capital raised. Strategies appearing to the right of the chart are achieving the best returns, while those carrying higher risk appear towards the top of the chart. Therefore, the strategies representing the best risk/return are located towards the bottom right corner. 

Over the measured 10-year time horizon, it can be seen that mezzanine and distressed debt have seen a higher level of capital inflows than direct lending. However, if you compare the standard deviation of net IRR for both strategies, direct lending offers investors a reduced level of risk at 8.4%, compared to the 12.2% offered by distressed debt. While the distressed debt strategy exposes investors to a higher level of risk, it does offer a stronger return with a median net IRR of 14%. Direct lending, offering a healthy median net IRR of 8.9%, may be seen as a superior risk-adjusted return by investors, on account of its lower standard deviation of returns.

While the direct lending market continues to grow, mezzanine debt has seen a drop in its capital inflows. This could be an indication of the growing interest in direct lending strategies and the result of companies seeking a cheaper, less intrusive debt solution. Importantly, from an investor’s perspective, the level of returns both strategy types offer are not dissimilar. For what many may consider a less established strategy, direct lending offers just a slight reduction in the median net IRR compared to the mezzanine figure of 9.5%.

Direct lending can offer strong risk-adjusted returns and the diversification investors seek. With the increase in fundraising for direct lending strategies and the strong level of interest from LPs, 2015 is set to be an exciting year for the strategy. 

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