NEW YORK (Reuters) – Miami-area fund manager Bob Press appears to offer the ultimate all-weather investment: a “direct lending” hedge fund that doesn’t require a long-term commitment and has produces nearly 90 consecutive months of positive returns uncorrelated to other markets.
Most funds invest in traditional financial assets like stocks or bonds, but direct lenders provide loans at high interest rates, usually to fledgling or distressed businesses through banks. Proponents claim that the strategy can produce consistent returns even in a low growth economic environment.
But as money flows into offerings like Press’s TCA Global Credit Master Fund, growing signs show that such stable returns may be at risk.
More than 30 investment professionals interviewed by Reuters list a variety of concerns: the influx of new money pushing credit standards down, increased leverage, and sometimes a mismatch between duration of investments and blocking periods.
A November survey by data tracker Preqin showed that nearly 40% of direct lenders believe loan terms have become easier compared to the previous year, and nearly a third said it was more difficult to find attractive borrowers.
Returns are also starting to drop to single digits, according to data trackers. (Graphic: tmsnrt.rs/2toxFGl)
Some of these investors have become more cautious and selective in their choice of funds. However, a small but growing group of those who adopted direct lending after the 2007-2009 financial crisis have said that they are now drastically reducing their exposure or avoiding direct lending investments altogether.
The rising risks, they told Reuters, could lead to much lower returns, or even a partial repeat of 2008, when a group of funds lost money and froze investor capital as borrowers failed. not repaid their loans and collateral was foreclosed.
Those who have pulled out include $ 1.4 billion Balter Capital Management LLC, which included direct lending as one of its top three strategies a few years ago and now has no money left, according to founder Brad. Balter. Greycourt & Co. significantly reduced its exposure to direct loans, as the money coming in made it much less attractive, according to Matthew Litwin, head of manager research for the $ 10 billion firm.
“With a few exceptions, it’s more risk for less return,” Litwin said.
Direct lending surged after the financial crisis when US authorities tightened credit standards for banks and ultra-low interest rates prompted investors to adopt less conventional strategies in search of higher returns. According to Preqin, US direct loan funds grew from about $ 33 billion at the end of 2008 to about $ 100 billion in June 2016.
The strategy remains popular as high equity valuations and historically low bond yields have boosted demand for private debt strategies. A Preqin survey of 100 institutional investors in January showed that 58 percent plan to increase allocations to lower-middle-market U.S. direct loans over the next 12 to 24 months.
However, several lenders and their investors told Reuters that the strategy’s ability to work in more difficult times has not been tested for years given relatively stable economic growth.
They say the flow of cash itself lowers yields and erodes lending standards by giving borrowers more options. Growing demand has spawned a slew of new funds, they add, which may lack experience in arranging loans in times of recession and rely on deals sponsored by private equity firms, which tend to be accompanied by higher leverage and lower returns than directly generated.
“There are a lot of Johnny-come-late considering all the new money. Inexperience hasn’t really shown itself yet, but it will, ”said Mark Berman of MB Family Advisors, LLC, another fund investor specializing in credit strategies.
Nearly 200 North American direct loan funds have been launched since 2009, according to Preqin, up from just 30 between 2004 and 2008.
Investment professionals interviewed by Reuters say lenders are more likely to enter into “lite” deals with fewer restrictions on loan terms, or deals where they weren’t necessarily the first to receive payments by. event of default.
Rising leverage is another red flag, a sign that investors and target companies are trying to stem the decline in yields by borrowing more.
Thomson Reuters data on unregulated non-bank lending arrangements shows that the debt of middle market companies has increased 16.6% in four years to an average debt-to-earnings ratio of 4.9 times.
TCA press acknowledges double-digit returns may be a thing of the past. The 53-year-old sees risks to the strategy as more money comes in, but notes that TCA does not use leverage and funds for all of its own trades.
Press expects his business – located next to a golf course in Aventura, Fla. – to continue to grow as banks remain reluctant to lend, allowing it to make profits on loans. and consulting fees. TCA started with a few million dollars under management in 2010 has grown to around $ 500 million and aims to raise an additional $ 300 million.
The promise of quick access to cash has helped smaller companies like TCA and Brevet Capital Management grow rapidly.
Large managers, such as Golub Capital, Czech Asset Management LP, and Monroe Capital LLC, require investors to commit their capital for three years or more.
But about two-thirds of funds have lock-in periods of one year or less, none of which, according to an eVestment study of 71 direct lending and asset-based lending funds for Reuters.
Those who offer generous withdrawal provisions say that the short duration of the loans and their diversity mitigates risk, and provisions that allow them to freeze funds are disclosed to clients.
“We are working very hard to avoid mismatches and to ensure that our loans match what we have promised to investors,” said Brevet founder Douglas Monticciolo.
TCA press said there was an inherent mismatch between assets and liabilities in open-end funds, even though the loans are short-term. “You can’t make it go away. You minimize it as best you can, ”he said.
Those who warn of heightened risks often remember the 2008 financial crisis, when a combination of loose liquidity, high leverage, and quickly soured loans hurt direct lending companies such as Plainfield Asset. Management LLC and SageCrest of Windmill Management LLC.
Plainfield, a more than $ 5 billion company located in Greenwich, Connecticut, ended up liquidating its portfolio and closing its doors following major customer buyouts and loan restructurings, even though it had cut back its debt before the crisis. Investors ultimately got $ 0.60 for every dollar invested, according to HFMWeek.
Plainfield founder Max Holmes told Reuters that today’s direct lenders could be similarly exposed whenever the next downturn occurs, especially those with insufficient capital. “We all have the same symptoms,” he said, citing relaxed lending standards and high leverage.
A former lawyer for SageCrest, which went bankrupt in 2008, did not respond to a request for comment.
The similarities are leading some seasoned investors to be cautious even as the money continues to flow and the economy continues to grow.
“We are increasingly cautious about the returns direct lending will generate,” said Chris Redmond, global head of credit at investment consultant Willis Towers Watson and an early proponent of the strategy. “The risks are starting to accumulate.
Editing by Carmel Crimmins and Tomasz Janowski