January 25, 2019 / 4:00 PM / 8 months ago

US middle market investors look to senior direct lending funds

NEW YORK, Jan 25 (LPC) - Middle market direct lending funds focusing on senior US leveraged loans are seeing a pickup in demand as investors seek protection in less risky debt in the late stages of the credit cycle, market participants said.

Platforms that lend to US mid-sized companies have been attracting record levels of capital across a range of strategies and funds, and hit a record US$87bn in 2018, according to LPC data, as demand for senior loan funds increased amid a deteriorating macroeconomic outlook.

In the next year to 18 months, more direct lenders are expected to raise funds focused on senior debt investments, according to John Mahon, a partner in the investment management group at law firm Schulte Roth & Zabel.

Middle market funds typically invest in senior loans, which offer more protection as they are first in line for repayment, and riskier second-lien loans with lower recovery rates. Boosting the allocation of senior debt is a defensive move designed to offset the risk of lending to smaller companies, which are more vulnerable in an economic downturn, and to improve recovery rates if companies run into difficulties.

Ares Management closed its inaugural US senior direct lending fund in January, which was heavily oversubscribed and raised around US$3bn in total commitments, exceeding an initial target of US$2bn. Including leverage, the Ares Senior Direct Lending Fund is expected to have about US$5bn in total capital available, the firm said on January 2.

The fund’s investor base includes pension funds, sovereign wealth funds, insurance companies, high net-worth individuals, family offices, fund-of-funds, endowments and foundations.

“In today’s market environment, we have witnessed increased demand for a floating rate, senior secured loan fund where investors of various sizes can access this durable and defensively positioned asset class,” said Mitch Goldstein, partner and co-head of the Ares Credit Group, in the statement.

Owl Rock Capital Partners, another middle market direct lending platform, filed a statement with the US Securities and Exchange Commission last year for a new fund targeting first-lien loans. The fund will be Owl Rock’s fourth direct lending fund since the firm launched in 2016, but is the first to focus on first-lien debt.

“We have shifted the focus of our private debt portfolio to senior lending strategies in recent years,” Michael Hitchcock, the South Carolina Retirement System Investment Commission chief executive officer, said in an emailed statement. “The Owl Rock First Lien Fund’s strategy is consistent with this focus. The fund will be concentrated on making first lien, senior secured loans to upper middle market businesses.”

A middle market investment firm in the last six months has also shifted its portfolio allocation to favor first-lien assets over a more even first-lien/second-lien split.

“There is a bias toward first-lien assets and a preference for investing higher up in the capital structure,” the investor said.

Investors concerned about market disruptions or economic conditions may find that first-lien loans offer a more conservative risk profile, a direct lender said.

As Libor continues to rise – the three-month benchmark companies peg interest payments to rose 63% since the start of 2018 through Thursday – returns on first-lien loans have also improved, which is making them increasingly attractive to investors on a risk adjusted return basis.

The average yield for first-lien institutional middle market loans was 7.86% in the first quarter as of January 24 up from 6.2% in the first three months of 2018, according to LPC data. Funds that employ additional leverage, can generate even higher returns on first-lien loans.

“In theory a manager that has a good handle on the relative risk profile can use leverage to achieve higher returns from relatively lower yielding assets that they otherwise would not have been able to,” Mahon said. (Reporting by Leela Parker Deo and Kristen Haunss. Editing by Tessa Walsh and Michelle Sierra)

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