LONDON (Reuters) - Demand from sovereign wealth funds seeking higher returns than those on mainstream bonds is helping drive a boom in specialist private debt vehicles that can provide loans for everything from aircraft leasing to lawsuit financing.
Such specialist funds make their returns in a number of ways, including lending to small and medium-sized firms, investing in distressed assets or by providing infrastructure project finance.
Once a niche sector, the private debt industry's assets under management swelled to an estimated $523 billion as of last June from $483 billion at the end of 2014, according to research provider Preqin in the latest data available.
Not long ago, such investments might have been too risky for the $6.5 trillion sovereign wealth sector, which invests governments' rainy-day savings, mainly from oil earnings.
But some 35 percent of the sovereign funds in Preqin's 74-strong survey now invest in private debt, up 11 percentage points from 2015, Preqin says.
The draw for SWFs, increasingly facing calls from governments to help fund budget deficits, is simply the yield that private debt offers. The average return generated by private debt firms tracked by Preqin was 5.76 percent over one year to Sept. 30, 2015, the most recent reporting data.
Faced with zero or negative rates in Western bond markets, a sovereign fund willing to sacrifice daily liquidity and lock up cash for longer can reap rich rewards.
"Liquid fixed income yields have compressed – that's a tough place to be for investors seeking yield," said Sanjay Patel, head of Europe at alternative investor Apollo Global Management, which has some $124 billion invested in credit.
Conversely, mezzanine debt has delivered a median average internal rate of return of 8-10 percent, whilst distressed debt has delivered 14-16 percent, according to a paper by Amin Rajan, chief executive of Create Research, in which he analyses Preqin data going back to the 1980s.
Mezzanine debt is a layer of financing that sits between senior debt and equity in a company's capital structure. This segment has attracted the most SWF interest so far, according to Preqin data, selected by 81 percent of SWF investors in private debt.
Distressed debt is the next most popular, attracting 69 percent of the SWFs who invest in private debt, then direct lending, which attracts 54 percent, Preqin said.
The industry has also grown due to the need for alternative financing since 2008 as global banks retreated from lending after the financial crisis, creating an opening for non-bank lenders especially in Europe and the United States.
"That has created quite an attractive investment opportunity," said Alex Miller, head of EMEA sovereigns, Middle East and Africa institutional sales at Invesco Asset Management Ltd. "When something is in short supply it can be priced reasonably well."
Specialist vehicles targeting private debt investments have raised bumper sums in recent years, with KKR closing a fund in April at $3.35 billion, whilst Fortress raised $5 billion for the largest distressed debt fund closed to new money in 2015.
Private lending is not without its risks, but these are more apparent where SWFs have forayed into bilateral loans - Abu Dhabi's IPIC, for instance, is locked in a bitter dispute with Malaysia's 1MDB over $1.2 billion that the former says it is owed.
Another example is a $25 million loan made by Abu Dhabi Investment Council (ADIC) to Mongolia's Golomt Bank that went sour in 2014.
Advocates for private debt funds argue that investing via these specialist vehicles enables investors to access a diverse set of credits and spread default risk.
Preqin estimates that such funds currently have $186.5 billion of "dry powder" available to invest. But deployment of so much capital could drive down returns, some fear.
Already infrastructure project finance debt, which has been popular with SWFs, has suffered some spread compression as more money chases the asset class, said Declan Canavan, head of alternative strategies at JP Morgan Asset Management.
But mezzanine debt, which is harder to originate and structure, and niche areas such as leasing of aircraft, cars and office equipment, or lending to small law firms, still offer potential, he added.
Others are venturing outside the United States and Europe for untapped opportunities. Abu Dhabi-listed investment firm Waha Capital is planning a fund focused on private lending to small companies in the Middle East where big banks tend to lend mostly to large or state-controlled entities.
"The real challenge is whether there are enough good investment opportunities to deliver (8-15 percent) returns," Apollo's Patel said. "As a fund manager, you don't want to chase yield down. We are already seeing some credit quality deterioration, across all credit."
Editing by Hugh Lawson