Institutional investors should look beyond mid-market corporate direct lending to other parts of the private debt universe, such as US residential mortgages or the UK commercial real estate debt market, according to Willis Towers Watson.

Private debt was now a core asset class for institutional investors, but concentrating on mid-market corporate direct lending was “much too constraining” an approach, the consultancy said in a report published last week.

Assets under management in private debt grew to a record $667bn (€557bn) at the end of 2017, up 13% on the year before, according to data provider Preqin. This meant the industry had more than tripled in size in the past decade, growing from $204bn as of the end of 2007.

Total assets in direct lending increased by $47bn since the end of 2016, the company added. 

Willis Towers Watson said mid-market direct lending was showing signs of “material deterioration in credit underwriting and future return potential”, and that investors needed to consider looking for better value elsewhere.

“At its simplest we are looking to identify borrowers in private debt markets with a genuine and credit-positive need for our clients’ capital,” the consultancy said. “In addition, we are seeking situations where there are greater barriers to entry for providers of debt capital like us.”

Other principles investors should bear in mind, according to the consultancy, included making sure the investment warranted sacrificing liquidity.

Chris Redmond, global head of credit and diversifying strategies at Willis Towers Watson, said it had become more challenging to find value in the private debt market following “meaningful” capital inflows in recent years.

“However, we feel there are compelling opportunities to be found if investors remain selective, with good value for risk taken for those investors willing and able to go the extra mile and unearth interesting opportunities,” he added.

Credit ratings agency Moody’s last month reported that its loan covenant quality indicator fell to its worst recorded level in the first quarter of this year. Derek Gluckman, a senior covenant officer at the company, said investor protections were “distressingly weak on average”, meaning that collateral might not be available in a bankruptcy scenario.

‘Not the reincarnation of the sub-prime mortgage market’

In a paper setting out such key principles, the consultancy highlighted the US residential mortgage market and the UK commercial real estate market as examples of where investors could “find value in surprising places”.

In the US, the non-qualified mortgage segment was particularly interesting, according to the consultancy.

There was a risk associated with this sector, it said, but this did not “represent the reincarnation of the 2006-08 subprime mortgage market”.

“Rather,” it said, “non-qualifying mortgages may present an opportunity for a highly discerning buyer to potentially achieve attractive risk-adjusted returns, with positive tailwinds for the US mortgage market and regulatory-linked barriers to entry.”

In the UK, meanwhile, regulation had helped to create “a highly attractive opportunity to provide short-term lending against non-income producing commercial real estate at a meaningful yield premium”.

“While we are cognisant of the potential for market dislocation in London commercial real estate, the short maturity (less than 12 months) of these loans, the reasonable loan-to-value ratio and being the senior lender (first mortgage) on the underlying property all help limit the risk associated with a market correction,” said Willis Towers Watson.

According to Preqin, 51% of investors surveyed at the end of 2017 had a positive perception of the private debt industry, down from 60% in 2016.

Reduction in commercial property lending by banks in the UK

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Source: Willis Towers Watson