(Bloomberg) -- Direct lending fundraising is slowing this year amid increasing competition from other investment strategies that take advantage of the financial and economic turmoil during the pandemic.
Fourteen vehicles focused on direct lending in North America have raised $10.2 billion in 2020, below the $14.2 billion during the first half of 2019, according to London-based research firm Preqin. It’s unlikely that money earmarked for the strategy will top the $29.7 billion brought in during all of 2019 or hit the peak of $34 billion from 2017.
“The private-debt fundraising environment is moribund, unless you have incumbency with a strong quorum of limited partners that trust and have previously invested with you,” Arif Bhalwani, co-founder of Third Eye Capital, which has C$2.5 billion ($1.8 billion) in assets, said from Toronto.
Direct lending, the most popular subcategory in the $820 billion private credit market, is facing stiff competition from other strategies taking advantage of the dislocation caused by the coronavirus pandemic. It is also facing headwinds as overall private-debt fundraising has eased from its highs.
Globally, private debt fundraising was down more than 40% in the first quarter, compared with the same span last year, according to Preqin, with many limited partners saying Covid-19 is disrupting their ability to make new investments in the asset class.
Capital allocated to the asset class will likely be earmarked for more opportunistic funds than it would have been six moths ago, according to Kevin Neubauer, a partner at law firm Seward & Kissel in New York.
“Distressed debt and recovery-focused funds have seen an uptick in the number of funds and capital being raised,” Neubauer said. “This clearly wouldn’t have happened to the same degree without the pandemic.”
A record number of distressed-debt funds are looking to bring in some $72 billion of capital amid a possible prolonged downturn, according to Preqin data.
New Normal
At the start of the pandemic, investors and managers alike saw a stoppage in activity as a “temporary blip,” placing investor diligence on pause. It has now become clear that this is a longer term issue, Neubauer said, so both parties have gotten creative in developing ways for investors to satisfy their due diligence processes remotely.
“I’ve heard of managers actually just taking a FaceTime tour of the office,” Neubauer said.
Over the last couple of weeks, Private Debt Partners co-founder Jeffrey Deacon also started to hear more firm commitments to timelines for investments.
“Rightfully so, people were on the sidelines for a couple of months to get a handle on how everyone will react to the new reality or the new normal,” said Deacon, who is seeking to raise C$750 million for a senior secured direct lending fund from pensions, family offices and endowments in Canada. He expects to see that investment activity pick up steam in the third quarter and into the fourth.
Still, some meaningful commitments to managers might not materialize until on-site meetings are possible, because larger institutional investors need to see physical work environments, meet key staff, and see how people and systems interact, according to Bhalwani.
One new prospective Third Eye investor said her endowment fund would not invest “without spending time in our office to ‘watch our team in action’ and gain insights that video calls and hard data simply cannot provide,” Bhalwani said.
Problems Ahead
The biggest challenge for private-debt managers will be dealing with problem loans and their liquidity. A manager preoccupied with defending a struggling or non-performing loan portfolio will need to use its cash to help heal its sick borrowers rather than taking advantage of lower risk, higher return credit opportunities in today’s market, Bhalwani said.
Managers with little name recognition in private debt, which has replaced banks in lending to small and mid-size businesses, will likely have the hardest time. Investors are drawn to larger, more established funds that have a track record through previous downturns and large existing pools of capital.
“There is a lot of concern about whether some private debt managers that have weak and vulnerable loan portfolios and little or no investable cash or dry powder will be able to survive through this crisis, especially those lacking the proper skill set and track record in loan workouts,” Bhalwani said. “The most successful fund raises in private debt more recently have been for funds that can flexibly pivot between listed credit and directly originated private credit.”
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