The hunt for yield in a low-rate environment continues to fuel investment in private lending, figures show.

The desire to directly lend to businesses and individuals and cut out intermediaries has grown rapidly in the US with assets linked to this approach almost at the $100 billion mark as clients such as wealth managers have gone beyond traditional channels to find returns, a report shows.

A Preqin/NXT Capital survey of almost 100 institutional investors active in the private debt space revealed that interest is focusing on the lower middle market in particular. The most cited reason for increasing allocations to lower-middle-market direct lending was the favourable risk/return profile of the sector compared to fixed income products.

In today’s low-yield environment, this appeal has led investors to commit more than $65 billon to North America-focused direct lending as a whole since the start of 2013, and consequently the assets held by US-based fund managers have grown to $99 billion as of June 2016.

The trend of investment in private debt, seen for example among private client wealth managers, family offices and private banks, can be explained by how this area is seen as offering superior returns to public markets, and because of how conventional bank lending has declined as a source of funding post-2008. This publication has reported on how private credit, as with private equity, has expanded as an investment area, although rapid expansion does carry certain risks, such as the likely eventual compression of returns. (For a related article on this point, see here and see here.)

According to figures from the Alternative Credit Council and Deloitte in 2016, the private credit market grew from $440 billion in 2015, to $560 billion (source: Financing the Economy 2016). In Europe, a boost is coming from institutional capital. In the US, the sector is by far the largest, in terms of total size and new assets raised. The research found that most financing is going to businesses with pre-tax profits of $10 million or more. Most loans are greater than $5 million in size and half are in the $25 million-$100 million range. In comparison, bond market financing, a common form of non-bank finance for larger corporates, is in the $100 million-$300 million range.

Private credit covers a multitude of channels including areas such as peer-to-peer lending platforms where conventional banks are taken out of the equation. This whole area is sometimes dubbed “alternative finance”, attracting the interest of the wider financial industry, and regulators. In the case of the latter, a concern may be that this is an area yet to be fully tested by a recession.

Among the details of the Preqin/NXT Capital report, the survey showed that private debt is a distinct allocation segment for 91 per cent of respondents, with 82 per cent allocating specifically to US lower-middle-market direct lending. Some 58 per cent of respondents expect to increase their allocation to US lower-middle-market direct lending in the next 12-24 months.

The majority of respondents (52 per cent) said expect senior debt products to offer the best opportunity within private debt. Most investors in US lower-middle-market direct lending funds have high performance expectations. Sixty per cent of survey respondents are targeting returns of 8-12 per cent from their investments. 

Meeting expectations
Direct lending funds have largely met those expectations, returning almost 10 per cent in the five years to June 2016.

Among reasons for investing are a manager’s track record (77 per cent) and the rigor of the manager’s investment process (52 per cent).

“This report demonstrates the strength of the lower-middle-market direct lending industry in the US, and the important role it plays in many investors’ portfolios. In a long period of depressed interest rates and low yields from traditional fixed income products, US lower-middle-market direct lending appeals to investors due to its risk/return profile, regular income, and low correlation to other asset classes. On this basis, it seems likely that interest and activity in the sector will continue to grow,” Ryan Flanders, head of private debt products, Preqin, said.