All you need to know about direct lending investments

The absence of value in fixed income assets and the rising volatility in equities has created renewed interest in alternative investments, which have become a key component of well-diversified investment portfolios. Initially, the asset class was mostly the domain of sophisticated investors, however, it has developed into products now available to much smaller portfolios.

Nevertheless, private banking clients remain underexposed to alternatives. Regardless of the rising transparency and regulations, hedge funds keep on suffering from image problems due to some bad practices in the past. Private equity funds offer the most attractive risk/reward profile, but the lack of liquidity can be an obstacle for private investors that have uncertainties surrounding the adequate time horizon and risk profile.

This is the primary differentiator between private investors and big institutional investors such as endowments and sovereign wealth funds, which have an exceptionally consistent investment strategy based on long-term objectives.

However, there are new segments in the alternatives space that could help to overcome the hurdles that discourage private investors from investing. One of the segments that are attracting investors is Direct lending. At a time when investment and wealth preservation is as challenging as ever, direct lending offers an option for asset managers planning to invest.

There is a growing trend for non-bank lenders to loan money to companies, cutting out the middleman. Indeed, institutional investment is now direct lending in the UK as it has been seen as a way to source alternative finance and funding for a variety of industries.

Direct lending started in the UK in 2005 with consumers borrowing from other consumers. Today, borrowers have increased and widened across many asset classes and the types of lenders have also expanded. Direct lending is also used to describe P2P lending and this reflects the growing number of diverse lenders keeping up with the high demand from borrowers.

Direct lending offers an attractive investment opportunity, gaining:

– Higher returns than a savings account could

– Lower volatility than stock markets

Likewise, borrowers are attracted by lower rates and quick loan decisions.

How do direct lending investments work?

Direct lending provides capital to businesses, entrepreneurs, and other investors. To make leveraged loans to borrowers, direct lenders raise capital from investors to fund a loan, without the need for a traditional lender. Hence, direct lending forms a part of the private debt market.

In recent years, the size of the private debt market has grown tremendously. As Bank of America research notes, the US private debt market has more than doubled in the last decade. It now exceeds $700 billion.

There are 3 primary reasons behind the growth of direct lending funds:

• Investor desire for fixed income with higher, more consistent yields
• A requirement for capital among middle-market companies, entrepreneurs, and investors, particularly those who can’t secure loans from traditional banks
• Following the financial crisis in the late 2000s, commercial banks retreated from lending to middle and small-market companies.

Since banks don’t lend to certain borrowers or for certain projects, direct lending funds fill a gap in the market. This brings opportunities to businesses and investors alike.

Direct lending funds can allocate capital to any industry where analysis shows the potential for strong, steady returns, from mid-market companies to local businesses. Industries can range from telecom to healthcare to retail. It varies across direct lending funds.

Why direct lending investment?

Other investment options aren’t as reliable as they used to be so it has become prudent to invest elsewhere. Stock markets stay volatile and thus difficult to find a safe haven for money now.

Add to this the diminishing yields on the usual ‘go-to’ investment products and savings accounts that presently offer little return.

Direct lending is additionally attractive when compared to other credit-grade investment choices:

• A gap in the market was seized

Traditional banks have decreased on business lending in recent times, particularly to SMEs, as tighter regulations have changed the post-financial lending culture. These tighter regulations aim to reinforce bank capital requirements and reduce leverage.

This has created an opportunity for alternative lenders and this gap in the market is being seized by investors who are offering loans to mid-market companies as an answer to low-yield problems.

Direct lenders can work under more favorable circumstances, therefore taking on the companies with high leverage simply because they don’t have to adhere to capital requirement guidelines. This results in comparatively attractive returns for the investor.

• Direct lending isn’t a passing fad

Direct lending was relatively undiscovered until recently, however, research by the Alternative Credit Council (ACC) has led them to predict that worldwide lending is expected to break the US $1 trillion mark by 2020.

The UK direct lending market is substantial and has developed considerably in recent years, with plenty of room for direct lending to keep on growing further.

The UK direct lending market accounted for £4.5 billion of lending in the year 2017, this is an increase of 21% in a year.

• Europe is catching up

In 2017, European direct lending grew to around the US $22bn, alongside the growth of mergers and acquisitions amongst SMEs. With SMEs looking for alternative ways to finance this growth, the two are intrinsically connected.

Institutional lenders presently account for more than half of the direct lending in the UK yet the UK media still remain skeptical about the industry. One of the reasons for this is that direct lending is frequently mistakenly confused with equity crowdfunding in the media.

Direct lending is much more established in the US and Asia and Europe are set to follow. In fact, shrewd P2P investment is helping clients who may not be able to get finance from banks and this, in turn, is injecting sluggish economies.

The borrowers benefit from loans that are secured and have straightforward and open arrangement fees from the start.

In turn, investors have the potential for attractive yields, low correlation, and low volatility compared to other asset classes. Direct lenders in Europe are teaming up to chase bigger deals and more high-profile firms.

• Rise in the number of investors

Direct lending began with asset managers lending to mid-market organizations and therefore filling in the gaps left by the banks. Now other types of companies such as P2P platforms are joining in and taking up the market for smaller loans, while the asset managers have the expertise for the larger loans – creating an even more prosperous and thriving investment climate.

In fact, in 2017 there were more than one hundred direct lending platforms facilitating more than £4.5 billion of lending.

In turn, fund managers can offer bigger loans as the cash flows, making direct lending more appealing with potential for returning clients.

Direct lending Investment v/s Real Estate Investment

When it comes to producing steady cash flow and consistent returns, real estate has long been king, especially multi-family investments.

If you look at the data thoroughly, direct lending still produces better returns, precisely because this type of debt financing offers higher yields. Since direct lending funds aren’t as constrained by capital requirement guidelines, they can lend to companies and businesses, people with higher leverage. If the deal goes smoothly, that equates to higher returns.

Still, for some, the advantages of direct lending investments may not outweigh the risks. Poor management of direct lending funds or lending to riskier borrowers can damage returns, especially in a downturn. So investors may seek the stable returns of real estate investment instead of a direct lending investment. That’s wise, but some direct lending funds offer a solution that gives you the best of both.

The downside of direct lending investments

The additional leverage that can make direct loans look more attractive is likely to put a damper on recoveries in a downturn. Borrowers might not like the fact that a single lender can have more power in negotiations than a group might. An uptick in creative earnings calculations could also set up borrowers in the space for more tight credit conditions and more downgrades. Lastly, new entrants to space may face challenges during a slowdown. Jamie Dimon, CEO of JPMorgan Chase & Co., has said some non-bank lenders may not survive an economic slump because they’re holding lower-quality loans, and in an April shareholder letter wrote that non-bank lending needs careful monitoring.

What does the future hold for direct lending investors?

The pace of growth in the direct lending market is slowing, however, this is all for the greater good as a ‘flight to quality’ is predicted as better lending platforms outperform weaker or less scrupulous ones.

However, there is still plenty of room for growth long term as reflected in the forecasting statistics. In 2018, there will probably be a rise in collaboration between direct lenders and traditional lenders, they will complement each other with banks seeing direct lending as a source of capital.

Another factor will be the concept of open banking which is spreading with an expanding influence across the financial world. For example, the UK’s Open Banking Initiative promotes the use of open application programming interfaces (APIs) to provide access to bank customer’s transaction data. This is certainly something to watch in the future with regard to how direct lenders can use this valuable data.

Direct lending will certainly experience change as it evolves in the coming years, however, it is here to stay as an alternative investment opportunity that offers great returns and eventually it is uncorrelated and relatively liquid in comparison to various other classes.