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The writer is chief executive of Martlet Asset Management, an adviser to the FDP Institute and retired co-founder of PAAMCO
Over the years, there has been a move by large institutional investors towards “newer” asset classes such as infrastructure and venture capital. The asset management industry’s focus on adding new asset classes has allowed investors to better tailor their portfolios to fit their risk and return objectives, while also reaping the benefits of diversification.
More recently, there has been a large surge towards private debt with a primary focus on direct lending. However, unlike other asset classes that primarily require investing in a market structure that already exists, the emergence of direct lending as an asset class has encouraged institutional, and now retail, investors to move to replace an entire ecosystem: that of traditional lending by commercial banks.
In many ways, on the surface, this has been a win-win for investors and borrowers. The 2008 financial crisis highlighted the role of highly leveraged and concentrated entities, such as money centre banks, which raise most of their funds from domestic and international money markets, in the real economy.
Transitioning direct lending so that it is done by unleveraged or much lower-leveraged, longer-term investors may seem like a good idea. This transition means replacing highly regulated commercial banks and their organisational structures with relatively nimble investment companies whose portfolio managers often excel at valuing and managing credit risk.
Plus, asset owners argue that in addition to yield, they benefit from direct lending as more of their portfolio is based on the valuations of the businesses to which they lend, rather than being forced to value positions on the shorter-term whims of the public bond market.
But when looking at this transfer of direct lending from the commercial banking world to that of asset management, there is at least one significant part of the ecosystem that, for many medium-sized companies and their loans, has no replacement in the current investment model.
The lending cycle includes origination, portfolio management and the key task that many commercial bankers have historically been involved with: managing stressed credits from initial covenant default through consensual restructure, while working closely with business owners on a long-term basis rather than a short-term transactional focus.
While many of these direct lending asset managers have strong credit modelling and underwriting skills, the absence of an individual who works with the company to solve financing issues before they become significant is noticeable. In other words, there is no one doing the job of a commercial banker.
There are two reasons why the stressed-credit function is not a large part of the direct lending done by asset management firms. The first is that very few direct loans have, at least until recently, been under much stress, and so asset managers have not needed to build the capacity to manage such situations. Moreover, many of the larger asset managers have the resources to onboard personnel if required (though the talent pool for experienced special asset credit managers is quite small these days, given the recent decade of easy credit and robust capital markets).
The second reason is that for many of these larger firms’ investments, the larger loans are sponsored by a private equity firm. If these loans start to run into trouble, the typical solution is for the asset manager to deal directly with the financially sophisticated private equity general partners. In short, many investors think that risk management merely involves one financial professional dealing with another.
But what happens when the music stops? When companies start experiencing balance-sheet stresses due to rising interest rates and, in some countries, slowing economic growth? The large asset management lenders in large private equity-backed deals will probably be OK, but the problem lies with smaller asset managers who have limited resources and invest mostly in non-sponsored loans for medium-sized businesses.
Who from these smaller shops is going to have the ability to work closely with these companies when they enter periods of uncertainty? If these managers do not have the skills, then to whom are they going to sell these loans?
As we replace the highly regulated banking industry with the more bottom-up, market-oriented asset management industry, prudent risk management demands that every investor should be asking: “What is plan B?”.