Back to School: Private-debt investors eye lower-middle market

Direct lending continues to grow as an asset class in a persistent low-interest-rate environment, and investors are particularly interested in the lower-middle market.

A survey by Preqin and NXT Capital of almost 100 institutional investors active in private debt found that 58 percent expect to increase their allocations to the U.S. lower-middle market in the next 12 to 24 months. Thirty percent indicated no plans to increase their exposure and just 2 percent said they would reduce it. Private debt was a distinct allocation for nine out of 10 respondents, with 82 percent allocating specifically to U.S. lower-middle-market direct lending.

Nearly a quarter (23 percent) of investors will add new portfolio managers in the lower-middle market in the next two years, and almost half (49 percent) said they will consider doing so. Investors expect U.S. lower-middle-market direct-lending funds to perform quite well, with 60 percent of respondents targeting returns of 8 to 12 percent.

Ryan Flanders, head of private credit at Preqin, attributed heightened interest in the strategy to “that continuous reach for additional yield within fixed income.” Other attractive features include being high in the capital structure, low volatility, higher recovery rates in down markets and slower default rate in times of stress.

As banks have reduced lending to lower-middle-market companies over the past decade, especially after the Dodd-Frank Act, alternative-credit providers have stepped in to fill the void. According to Preqin, they now provide most of the capital to this sector. Assets under management among global direct lending managers grew from $10 billion to $153 billion from December 2006 to June 2016, with the U.S. accounting for almost $100 billion.

Six of the 10 largest allocators to the asset class have been insurers and pension funds, large institutions seeking higher returns without additional risk, compared with traditional fixed-income products. The median net IRR for fund vintages 2004 to 2014 was 8.9 percent, with a small standard deviation by alternative-asset standards.

Flanders said most direct-lending investors take a generalist approach, though some will avoid certain sectors, “say retail and oil and gas, anything energy-focused.” Some niche players target restaurants, aircraft, SaaS or healthcare, sectors in which “it’s a different underwriting process, so having that specialty makes sense.”

“Timing the market is coming to people’s minds,” Flanders added, as we enter the ninth year of recovery since the Great Recession. “There’s a lot of interest in distressed credit, special situations in anticipation of some sort of hiccups in the market as a whole.”

Action Item: Contact Ryan Flanders at +1 646 376 7069. See the survey results here.

Voters head to the polls for the U.S. presidential election in a one-room schoolhouse near Colo, Iowa, on Nov. 8, 2016. Photo courtesy Reuters/Scott Morgan