By Daniel Lanyon on Tuesday 28 February 2017
Last year was a strong one for direct lending, but new research suggests sentiment is still improving to alternative forms of fixed income.
Institutional investors are likely to increase their holdings in direct lending funds in the near term, according to a new report by consultancy firm McKinsey.
The latest McKinsey Global Private Markets Review, entitled ‘A routinely exceptional year’, found demand was increasing for funds in the direct lending space – sometimes termed as “private debt” thanks in part to a growing cynicism of public debt assets such as bonds.
Investors, the report found, are dealing with an “extraordinary number of wild cards” at play, most pertinently geopolitics above all, particularly around Brexit and in the United States. Also, the direction of travel of tax, trade, and infrastructure, and sectors such as healthcare, energy, defence, and industrials.
While these unknowns will create opportunity, they are also making risk and risk premia, harder than to calculate. This has prompted a belief that public markets, despite their recent run-up, are becoming structurally less attractive. As a result, many are likely respond by further raising their allocations to private markets.
Within the institutional bracket, McKinsey’s research suggests that family offices are the most bullish on alternative credit, as demonstrated in the chart below.
In the world of closed-ended direct lending funds in Europe and North America, fundraising fell in 2016 following a four-year bull run despite interest in this alternative credit remaining strong.
The report’s authors said: “In Europe (particularly Germany), demand for private debt has risen because stricter regulation and capital requirements have constrained banks’ ability to lend to midcap companies. In Asia, however, the attractiveness of private debt has been tempered by concerns over spreads.”
In countries that lack more formal debt markets such as India, however, McKinsey found investors typically bear a higher cost of capital, which makes the risk-reward calculus on private debt spreads more unattractive.
“In more formal debt markets (such as Japan, Singapore, or South Korea), spreads are often insufficiently attractive because debt is either too cheap (as in Japan’s negative-interest-rate environment) or too efficiently traded (as in Singapore or South Korea),” they said.
The report also found that the largest funds—those with more than $5bn of assets under management— are capturing a bigger share of new capital (or at least have done over the past five years). This reached a peak in 2016 with one in every four dollars raised in private markets going to a ‘mega-fund’ of more than $5bn, and nearly 60 per cent of all fundraising went to funds larger than $1bn.
“More evidence of these trends comes in the growing “ticket size” of the average LP commitment to a single fund, up 47 per cent over the past five years to $50m.The mega-funds’ growing prominence is due in part to LPs’ desire to consolidate their holdings with fewer GPs. The larger allocations that result are more readily absorbed by the biggest funds,” the report said.
Other factors might also explain the surge. The largest funds are typically raised by larger firms with stronger marketing and investor-relations capabilities, including strong brands. Picking the best is fund managers is a perennially difficult task and in the absence of easily digestible track records, many investors are likely to opt for a more well-known name.
A separate but also recent report by data firm Prequin found that among global institutional investors, sentiment to alternative credit was higher than any other form of alternative assets.