14% of Europe’s pension funds to invest more in direct lending – Cerulli

Fourteen per cent of Europe’s pension funds will invest more in direct lending in the next two years, according to Cerulli Associates.

Its latest report, The Cerulli Edge – Global Edition, found that direct lending funds continue to exploit opportunities arising from the withdrawal of banks from the ‘risker’ end of the market.

More so that pension funds, insurers are showing a strong interest in the funds. Cerulli Associates associate director, European institutional research, Justina Deveikyte, said that the growing confidence of fund managers is reflected in their willingness to write larger tickets and their belief that returns can be maintained even as the number of funds grows.

In addition to some banks pulling back from riskier lending, the number of banks in the market is falling. Cerulli data on the number of credit institutions in the EU, derived from European Banking Federation figures, shows that the number of branches of non-European-Economic-Area-based banks operating in Europe fell from 7,315 in 2010 to 5,107 last year.

Cerulli analysis shows that direct lending assets under management in Europe have grown steadily over the past six years, rising from €25.6bn in 2014 to €87.4bn at the end March 2019. Preqin data tracking Europe-focused direct lending fundraising over the past decade indicates that the number of funds launched in 2017 (35) was not matched last year and is unlikely to be matched in 2019 based on year-to-date figures.

However, the total funds raised in 2017 (€26.5bn, also the highest over the past decade) could be equalled or exceeded in 2019. To date, 21 funds have raised a total of €22.7bn this year. At the end of 2018, these funds were sitting on €45.9bn of dry powder and an unrealized value of €60.7bn.

On the question of whether direct lending funds can maintain their current returns even as the number and size of funds increases, Cerulli’s research suggests that the downward trend in return levels has bottomed out. Net return expectations of direct lending currently stand at 6-7 per cent per year. Direct lending funds typically have a 5 per cent hurdle rate for their carried interest.

Noting that direct lending in Europe has not gone through a full credit cycle since it gained prominence, Deveikyte said there can be no certainty as to how direct lenders would approach distressed situations.

Concerns have been raised that some funds do not have the resources to deal with the demands of restructurings while continuing to originate new deals. Investors pay close attention to managers’ team size, their ability to navigate a distressed market environment, and their capacity to cope with restructuring or defaults, Cerulli said.

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