A challenging feature of the recent financial markets turmoil has been an increase in cross-asset correlation—different asset classes moving largely in tandem. This has been due to a few factors, in particular the market’s overwhelming focus on inflation and central bank policy. But this poses a challenge for investors who wish to diversify their investments, as certain asset classes within equities and fixed income find themselves rising and falling in unison.
The increasing reach of direct lending strategies is one avenue of diversification, and investors are taking advantage of its benefits. Direct lending—providing financing to borrowers directly rather than through an intermediary like an investment bank—is an asset class that has grown rapidly. According to law firm Harvey Shirley, direct lenders raised a total of US$112 billion in 2021, accounting for some 58% of all global capital raised by credit funds. However, the market is likely much larger, as deals are most often private and therefore not tracked in the same fashion as public investments. By some estimates, the private credit market in total may be closer to US$1 trillion across asset classes.
Direct lenders provide financing to borrowers that may not have access to markets such as institutional bank loans or the public bond market. This is often due to their smaller size—many credits in this space have EBITDA (earnings before interest, taxes, depreciation, and amortization) of US$10 million—US$100 million, which is typically defined as the “middle market”. However, larger companies also seek out private financing markets due to the certainty of price and capital amounts that can be provided in a transaction.
For the companies, direct lending provides a crucial source of capital, as large banks have retrenched from the middle market due to stricter regulations following the Great Financial Crisis. As a result, private lenders have moved in to fill the void. Growth in this market has been driven by flexibility in how deals are structured, relationship-oriented transactions, and consistency from lenders. Also key is the overall growth of private equity over the last two decades.
For investors, the retreat of large banks from the mid-market sector has created a rapidly growing investment opportunity with compelling dynamics. Notably, direct lending tends to offer higher risk-adjusted returns than what are available on public markets for similar investments such as syndicated loans or bonds. As private market investments, they are also less correlated to the peaks and valleys of public markets, where investment valuations are marked to market daily (adjusted to reflect the direction of the overall market). This tends to reduce the volatility of private market investments, which employ a hold-to-maturity investment strategy.
While higher returns are typically associated with higher risk, direct lenders’ diligence is meant to understand and unravel real risk from perceived risk. Asset managers actively curate their portfolios through deep due diligence, direct connections with management and owners, and consistent monitoring, often resulting in better outcomes for investors. Additionally, lenders are able to directly negotiate credit agreements to structure better terms, covenants, and pricing mechanisms with the intention of providing downside protection and principal preservation for investors.
Other aspects of the asset class that help reduce correlation and volatility include their pricing structure and security features.
Directly placed loans are often structured with floating rate coupons, which limits the impact of interest rate volatility on the value of the loan and provides a consistent yield. Additionally, direct loans are often secured by first-priority liens on company assets, which gives them seniority over bonds in the case of default. Historically, this has resulted in lower losses than other fixed income instruments during periods of stress. As with many private investment strategies, the tradeoff is that the illiquidity of the investment means investors are typically unable to trade in and out of positions easily. However, this results in an ‘illiquidity premium’ that contributes to the attractive return profile.
The aforementioned benefits of direct lending—favorable risk-weighted returns, less correlation to public markets, and more active management, among others—drive direct lending’s value as a diversifying investment strategy during a period of cross-asset correlation. This has been most evident in the volatile path followed by bond yields and equity prices this year. The inverse relationship between bond prices and yields results in a correlation between stocks and bonds. Ultimately, this reduces the value of the traditional 60/40 portfolio, where the 40% fixed-income allocation is meant to act as a stable income source that typically offers offsetting gains when stock markets are weak.
The low correlation combined with the risk-adjusted return potential of direct lending makes it an appealing investment option for investors seeking credit alternatives. The key to success is ensuring your investment manager is experienced and has a strong track record of navigating multiple cycles.
For investors looking for expert guidance and diversified strategies, Harbour Investment Partners provides tailored investment solutions that can help navigate complex market environments. Their experienced team can offer insight into opportunities like direct lending and other innovative credit strategies to help protect and grow your wealth.
Additionally, Harbour Investment Partners specializes in offering credit investment opportunities that provide favorable risk-adjusted returns with less correlation to traditional public markets, making them an excellent choice for portfolio diversification.
