Direct lending funds and the gap in Small Medium Enterprises (SMEs) financing.

Direct lending funds have emerged since 2008 as a viable alternative investment to conventional credit and debt-based investment fund strategies.

The financial crisis proved to be a major wake up call for many investors with exposure to credit, as liquidity drained out of the financial system in the wake of the collapse of Lehman Brothers, and many credit hedge funds were closed to new redemptions.

Direct lending funds do not invest in securitised debt or any other esoteric, debt-based strategies. They pursue a more traditional strategy for lending money to businesses and projects. Direct lending funds typically control one or more finance companies that carry out the day-to-day lending and credit analysis activities that are key.

What are the key characteristics of successful direct lending funds?

Market knowledge: most direct lending funds will focus on a particular sector or geography – the farming industry in the UK, for example. Part of the edge for a direct lending fund will be knowledge and expertise which the finance teams bring to the strategy. Frequently direct lending funds will employ personnel with strong commercial finance backgrounds and expertise in the sector they focus on..

Unlike credit funds, direct lending funds are in contact with their underlying customers on a regular basis. The direct lending teams carry out detailed and ongoing due diligence of companies to assess credit risks. This provides direct lending funds with additional advantages in terms of the level of transparency and risk management they can achieve.

Are direct lending funds susceptible to the negative impact of an economic recession?

This really depends on the sector they specialise in. For example, if the direct lending fund is lending to companies with a solid underlying asset that the loan can be secured against, and one that is unlikely to lose its value, then the fund is more likely to preserve value in the event of an economic downturn.

Direct lending funds are often based on a predictable portfolio of loans that provide a regular income stream to the fund. The managers focus on ensuring that the portfolio of loans is diversified across a range of risks within the sector they invest in. This can include both viable existing businesses and new projects, for example, in the infrastructure space. This does not mean direct lending funds should be classed as infrastructure funds, as the characteristics of the financial arrangements can be different. In addition, direct lending funds can combine both infrastructure and business loans within the same strategy.