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Direct Lending and Institutional Investors

October 24, 2017

Asset managers are providing loans to mid-market companies without banks or other lending institutions acting as intermediaries. This type of lending arrangement is known as “direct lending,” and it targets businesses in need of credit and lending options that might be overlooked by banks. Recently, asset managers who provide direct lending are targeting more high-profile firms and larger deals.

Direct Lending Activity on the Rise

According to Deloitte, investment for direct lending amounted to about $13.3 billion in the first quarter of 2017. This is more than half of the total for 2016. A majority of direct lending — 61% — occurs in the U.S. A Preqin study showed that private credit providers had $595 billion in assets under management as of June 2016. 

Funds such as Capital Dynamics and Pine Bridge are starting direct lending businesses that target markets in the U.S., Europe, and Asia. Smaller asset managers are also entering direct lending, as middle markets may offer less competition. 

Such funds may provide individual investors access to market opportunities that were typically the realm of larger institutional investors. In the past few years, institutional investors have also been raising allocations to direct lending, private debt, and other similar opportunities in order to increase diversification. 

Characteristics of Direct Lending Activity

Direct lending businesses primarily lend to middle-market companies that are seeking capital for growth, acquisitions, leveraged buyouts, and recapitalization. Assets in a direct lending business can be broad and may include bank loans, structured credit, middle-market loans, and other forms.

The objectives of direct lending businesses and direct lending projects include:

  • Generating current income as well as capital appreciation
  • Providing assets with low volatility
  • Providing assets that have low correlation to broader markets
  • Seeking risk-adjusted returns
  • Capturing higher returns than other fixed-income investments

Direct Lending Risks and Drawbacks

While the past few years have been favorable for direct lending investments, there are several factors that could present risks for the industry. Some of these include:

  • Competition: Rising investor interest may eventually cause the space to become overcrowded
  • Deal quality: Fund managers tend to be paid based on invested capital rather than committed capital; this may put pressure on managers to find deals simply to put the capital to work
  • Barriers to entry: A highly qualified team is generally required to scout opportunities
  • Rising interest rates: Direct lending was partly shaped by the low-interest rates that characterized the past few years. Direct lenders may see more competition from commercial organizations as interest rates rise
  • Downturn in markets: Many firms that have entered the direct lending market haven’t experienced a market downturn yet; it remains to be seen how they will react to such circumstances
  • Regulation: Financial deregulation could remove many Dodd-Frank-related provisions that rendered banks less competitive. While these changes are not set, they could lead to increased competition in the long run

In order to remain competitive as direct lending increases, fund managers should develop more customized portfolio options and return products for institutional investors. 

The current unregulated direct lending environment does mean that more direct lenders may be extending higher-risk debt financing options to companies in need. Vitor Constancio, vice president of the European Central Bank, has stated the need for pre-emptive regulation of non-institutional lenders in order to prevent systematic buildups of risk. 

New Regulations Allow Limited Direct Lending to Italian Borrowers

Traditionally, lending activity in Italy was restricted to financial institutions that were directly regulated by Italian authorities. This arrangement required foreign financial institutions to use “Italian Bank Lender of Record” structures to advance funds to an authorized Italian lender, which would then advance the funds to Italian borrowers. This system often exposed investors to various credit, regulatory, and tax risks. 

Earlier this year, Italy implemented the Italian Financial Act, which allows direct lending into Italy through EU Alternative Investment Credit Funds (EU AIFs). The new rules aim to modernize the investment situation in Italy and increase direct investment into Italian Credit. 

The Italian Financial Act allows EU AIFs to conduct direct lending activity in Italy, subject to specific conditions, which include:

  • Lending activity to Italian consumers is restricted
  • The EU AIF must be authorized to engage in lending and investment activity in its EU jurisdiction of formation
  • The EU AIF must operate as a closed fund
  • The EU AIF’s operating rules must be similar to those that apply to Italian AIFs

In addition, there are various requirements regarding notices of approval to the Bank of Italy, as well as ongoing obligations to keep the Bank of Italy informed of any structural or status changes.

These regulatory changes in Italy may signal a change in the unregulated nature of some direct lending activities, and they may create some consistency in the way that such activities are processed. For institutional investors, managing risks includes staying informed of these types of regulatory changes.  

Effects of Direct Lending on Institutional Investors

Direct lending is allowing individual investors access to markets that were once primarily the domain of larger institutional investors. In order to adapt to the competition, institutional investors should continue to employ innovative methods for managing portfolios and generating returns. In particular, fund managers should stay informed regarding global regulatory changes that could affect their access to local markets. The creative use of data will be key for institutions to remain competitive. 

The legal rules and regulations governing direct lending are currently subject to adjustments as different jurisdictions adjust their policies and goals. If you have any questions regarding direct lending and other issues that can affect institutional investment activity, contact us today at Kessler Topaz. 

We work closely with institutional investors to monitor their portfolios in order to properly advise them as to potential securities claims and other events that might affect their assets. At no cost to our clients, we investigate all potential actions and cross-check those against our clients’ trading histories. As a result, our clients are in the best position to protect their rights and interests during all stages of litigation.