March 23, 2017 / 3:23 PM / 4 months ago

LPC-Pension schemes pour money into European direct lending

LONDON, March 23 (Reuters) - Pension schemes are pouring money into European direct lending strategies, fuelling the growth of larger funds and the arrival of new entrants willing to lend to leveraged European middle market companies.

Hayfin Capital Management raised more than €3.5bn for its European direct lending strategy in February, while Park Square Capital and Japanese bank SMBC are setting up a new €3bn direct lending joint venture.

Alcentra, the alternative fixed income arm of BNY Mellon Investment Management, raised €4.3bn for its European direct lending strategy this month -- a marked increase from its first fund close in 2014 which exceeded €1.5bn.

“I would say the difference between our first and second fund is we’ve seen a much larger investor base from the UK and Europe,” said Graeme Delaney-Smith, managing director and head of European direct lending at Alcentra. “I think after having done their work and their due diligence, they have now taken their opportunity to invest.”

He said pension funds have been a large contributor, as well as an uptick of interest from insurance companies.

“It’s an asset class that they didn’t really have access to before because the banks were by and large the sole provider of middle market lending across the European market – that has obviously changed.”

Stepping Into Banks' Shoes

Since 2007, asset managers have been stepping into banks’ shoes to lend money directly to leveraged European middle market companies as banks retrenched or repositioned following the financial crisis.

A decade on, the appetite for the strategies is only increasing among pension funds and other institutional investors hungry for returns and wary of increasing volatility in other markets.

Earlier this month, a Natixis Global Asset Management survey of 500 global managers found that faced with volatility, greater risks and still-low yields, institutional investors are currently raising their exposure to higher-risk assets – with 44% considering increasing the use of direct lending in the next 12 months.

“I would say momentum is really starting to build now,” said Rohit Kapur, senior fixed income manager researcher at consultancy Aon Hewitt. “A lot of pension schemes at the moment are taking first steps in the asset class.”

He said pension schemes are interested in direct lending because they receive an illiquidity premium over high yield bonds or leveraged loans, and are also more comfortable with the strategies now some managers have established a track record in the market since it took off in earnest around 2012.

Pension funds originally invested in syndicated leveraged loans via managed accounts, attracted to larger, more liquid and less risky loans. However, with pressure on pricing, covenants and documents, syndicated loans are losing some appeal in comparison with direct lending, which offers higher returns on covenanted loans with better documents.

This has gone a long way to counteract the illiquidity of direct lending, which pension funds previously had an issue with. The benefit of liquidity was also lessened in a low yield environment.

“You don’t have liquidity in the mid-market but the biggest problem that pensions funds have is generally deploying money and getting any yield. How worried are they if their money is put to work but locked in, if they are generating a 5%-7% return?” a senior direct lender said.

Hayfin managing director Glenn Clarke added: “Investors in direct lending strategies are compensated for the illiquidity on the basis that both the arranging fees and coupon are typically higher than those of syndicated loans. Furthermore, middle market credit exposure is a diversifier to typical syndicated portfolios.”

Pension funds also face a wider choice as the direct lending market matures, ranging from senior debt options which pay around 5%-7%, to higher-yielding unitranches that can pay into the high teens, depending on risk appetite.

“There is definitely increased demand but on the flip side we are seeing increased supply -- so new managers or existing managers are raising larger funds than before,” Kapur said.

As the market develops, Kapur said he also expects to see managers offer investors more liquid hybrid funds.

“One development you’ll start to see more of over the next couple of years is managers coming out with hybrid products that are a combination of more liquid leveraged loans and middle market loans you typically see in direct lending.”

Allocations

Pension funds have generally been de-risking their portfolios since the financial crisis, moving out of equities and into assets that better match their liabilities.

To invest in direct lending, they have been re-allocating away from lower-yielding fixed income assets or moving further out of equities.

“What we have tended to see clients do is reduce allocations to investment-grade and equities to make a risk neutral move into alternative credit more broadly, including direct lending,” said Gregg Disdale head of illiquid credit at consultancy Willis Towers Watson.

The senior direct lender added: “Credit is safer than the rollercoaster ride of the equity markets and in the end, pension funds will most probably get the same returns. The returns from direct lending are basically just as good as equity.”

Pension schemes have been carving out an allocation of 5%-10% of their entire portfolio to private debt, including direct lending, real estate debt and infrastructure debt, said Sanjay Mistry, director of private debt at rival consultancy Mercer.

This sits between their fixed income and alternative asset allocations, he said, rather than falling into one or the other. Funds are also starting to invest across different managers to diversify their portfolios.

Direct lending funds may include around 20 names compared with more than 150 in a leveraged loan portfolio – which heightens the risk that if one deal goes awry it will affect the fund’s performance. (Editing by Christopher Mangham)

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