‘Dry powder’ loan funds struggle to find a home

Funds making loans to companies that are privately owned have proved highly popular among investors over the past decade. But some allocators now fear that their strong asset growth and an uncertain economic environment could put pressure on returns.

The private debt sector has been one of the most favoured alternative asset classes since the financial crisis, ballooning from less than $400bn worth of assets at the end of 2008 to an estimated $1.2tn at the end of last year, according to data group Preqin.

Its seemingly reliable and consistent returns have attracted yield-hungry investors during a prolonged period of ultra-low interest rates.

But some now wonder whether funds are struggling to find suitable places to invest all the capital they have raised and, when they do invest, whether margins are lower and covenants looser.

“People should be worried about the amount of capital in the private space, both invested and the amount of dry powder [unallocated capital] seeking investment targets,” says Jim Neumann, chief investment officer at Sussex Partners, which advises clients on alternative investments.

“We don’t advise clients to do a lot more in private credit at this market juncture, as there is a shoe to drop there.”

This so-called dry powder piled up during the coronavirus pandemic, according to Preqin. Many investors committed capital in 2020 in anticipation that Covid-19 would create a wave of distressed opportunities. But, instead, they found that huge levels of government support for business limited these opportunities, leaving more capital unallocated.

Total dry powder in the sector stands at a record high of $405.4bn, as of March this year, up from $118.4bn at the end of 2011. However, the amount of committed but unallocated capital as a proportion of the sector’s total assets was higher a decade ago than it was last year.

Some in the industry argue that the fact that dry powder’s share of total assets has not risen shows the sector still has plenty of room to expand.

“My reaction, when I hear that ‘so much money has gone in’ [to the private debt sector], is that this market didn’t exist before 2008 or 2009 in Europe,” says Kirsten Bode, co-head of pan-European private debt at investment firm Muzinich & Co.

“Dry powder has been pretty constant — volume has increased, but in line with assets under management,” she says. There was “no reason”, she adds, why the sector should not be as big as the private equity industry, which has about $5tn in assets according to Preqin.

Private debt — a sector that includes direct lending, as well as distressed and mezzanine debt — has grown in importance by filling the gap left by banks as they cut back on riskier lending to small and medium-sized companies.

For borrowers, a loan from a direct lending fund can be more attractive than a syndicated loan because of the relative simplicity of negotiating with one or a handful of such funds. Money can also be accessed more quickly, although the rate of interest charged may be higher.

For lenders, though, there are signs that the weight of money invested has pushed down protections in some areas of the market by reducing or loosening covenants — even though most deals still have at least one covenant, according to S&P Global.

“The very upper end of the mid-market”, where the biggest direct lenders operate, “has become very competitive, and they have had to make some concessions on margins and covenants to get deals done”, says Andrew McCaffery, global chief investment officer at Fidelity International. Nevertheless, he thinks loans to mid-market firms are still attractive.

Returns have also been on a downward trend, with the rolling three-year internal rate of return dropping from 8.5 per cent in 2015 to 5 per cent in 2020, according to Preqin.

Some investors are already steering clear. Michele Gesualdi, founder of London-based investment firm Infinity Investment Partners, for instance, says he invests “very little” in the sector as it is “highly asymmetric” given the “low return[s]” on offer relative to the risk.

And, as the global economy enters an era of high inflation and rising interest rates, with Russia’s invasion of Ukraine threatening economic growth while adding to inflationary pressure, some see that risk increasing.

Floating-rate loans linked to rising borrowing costs can offer investors some protection on real returns, but inflation and higher financing costs threaten the creditworthiness of some borrowers grappling with rising input costs. If high oil prices and sanctions against Russia lead to a sharp contraction in the global economy, that could put the sector under pressure.

Fidelity’s McCaffery suggests the sector will be “better insulated than many other asset classes” from the impact of inflation and growth shocks. But his firm has been analysing companies’ ability to absorb higher prices and the impact of any fall in economic demand, he adds.

“The resulting inflationary pressures [from the war in Ukraine] — and the impact that has on consumer demand and growth — is likely to affect borrowers from across the markets,” he says.