(Fixes typo in first paragraph)
By David Brooke
NEW YORK, June 3 (LPC) - US direct lenders, grappling with intense competition in the US middle market, are lowering the fees they charge to investors and adopting other aggressive terms as they look to adapt to an intense new lending landscape.
The proliferation of private credit and direct lenders in the last three years has resulted in an intense race among new and existing players to raise capital, build scale and show returns. It is harder for new entrants that lack the wider platform to absorb the costs that go into establishing themselves in a crowded market.
“The market is becoming more mature and fees are evolving. The structures can be specific to the firm. Experienced managers with four or five funds may have a template and new entrants are likely to offer discounts and breaks,” said one fund manager.
Middle market direct lending strategies raised US$96.9bn in 2018, up from US$70.9bn and US$62.6bn in 2017 and 2016, respectively, according to LPC, a unit of Refinitiv.
Mean management fees for 2019 vintage funds stand at 1.5% and performance averages are 19%, according to data from Preqin. This is up slightly from 2017, when a post-financial crisis record number of funds were set up, dragging average management and performance fees down to 1.5% and 16.9%, respectively.
In 2014, management fees averaged 1.8% and performance fees were at an average of 20%, according to Preqin.
To offset the market pressure on fees, some managers are also setting lower hurdle rates, which represent a minimum figure that a manager has to hit before they are paid for fund performance.
A guideline hurdle rate is around 2% below the expected return for the fund. Preqin data shows that rates for all private debt asset classes were at the lowest in 2017 at an average of 7.1% before coming back up to 7.5% in 2018 and 2019.
For vehicles providing senior loans, this range has fallen to around 5-6% as a result of a price compression for unitranche loans in the last couple of years following the increasing number of funds now offering the loan structure to borrower.
A unitranche is the combination of senior and junior debt into a single loan at a blended cost for the borrower. Some investors have questioned why hurdle rates are coming down in what had been a rising rate environment until this year. With loans being a floating-rate instrument, the rate increases provided extra yield for lenders.
“It has been disappointing to see hurdle rates come down with base rates going up. Why should the two have an inverse relationship to each other as spreads haven’t come down as fast as base rates have increased over the recent years?” said Niels Bodenheim, senior director at bfinance.
“(Fund managers) are looking at it too simplistically. There is margin pressure over the base rate, but they should also look at it from the (investor’s) perspective seeking an alternative solution. Spreads haven’t compressed enough to warrant that offset,” he added.
The US Federal Reserve took a dovish turn in December and again in March indicated it would keep the benchmark rate at 225-250bp for the rest of the year.
With managers setting up funds in the anticipation of continued rate rises, the sudden change means many have to look up the risk curve to hit the yield targets set for investors, especially as unitranche returns continue to come down.
“Unitranche remains fashionable,” said Terry Harris, Head of Portfolio Management, Global Private Finance at Barings. “A lot of new managers, as well as old money, have set high target net returns, forcing them further out in the risk adjusted return curve.”
“The 25bp-50bp ‘certainty’ premium that came with unitranche has been eroded, given the increasing amount of private debt capital available to fund unitranche loans relative to issuer demand,” he added.
Firms have tried to get more creative with their structures to win over investors and adapt to the changing macro environment.
Other strategies include tailor-made managed accounts as well as investment periods extensions to four years from the traditional three in order to position themselves for a downturn that may bring higher yielding opportunities. (Reporting by David Brooke. Editing by Michelle Sierra and Leela Parker Deo)