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Why Debt Funds Are the New Industry Darling

With a booming M&A market, traditional investors have competed to get into the hottest PE funds, leading to record capital raises. Now institutional investors have set their sights on another opportunity: private credit funds.

Following the financial crisis, banks essentially shuttered their lending arms. Others trickled in to fill the void, with financial companies leading the way at first. Now all kinds of firms use private credit tactics. Though interest as risen for years, it reached a frenetic pitch in 2017. Fundraising soared more than 35%.

Big private equity firms such as KKR, Apollo, and The Blackstone Group have eagerly made their presence known in the space. After all, debt is in high demand among PE deal-makers. It offers solid returns, with few regulations. The debt market has exploded over the past eight or so years. When banks pulled back, it left skilled lending teams without a home. Many joined up with new financial institutions and started new lending arms.

Over the past few years, middle market private firms are showing an increased interest in private credit. H.I.G. Capital’s Whitehorse Capital, for instance, closed on $1.1 billion in direct investing 2017.

Businesses will always need loans. Institutional investors want in on these money-making opportunities. Gryphon Investors, middle market PE firm, closed its first fund, Gryphon Mezzanine Partners LP, with $100 million.

The big challenge here for PE firms is having potential competitors as creditors. The situation is volatile, and rapidly changing. Information leakage can be a problem, and debt and equity sides of the house must build Chinese walls that work well.

Insurance companies are also growing abundantly in the space. While some already have lending capabilities, many are growing their offerings. Manulife Financial Corp. expanded in 2017 to offer senior credit to the middle market. The insurance company.

Numerous insurance companies were active in mezzanine finance for years. These larger offerings are a natural extension of what they have done for a long time. It makes good financial and logistical sense. The big fear is that some of these new groups have not managed a fund through a financial crisis. Markets aren’t the same as what they were during the last financial crisis. So things feel different, but the next crisis will come. And it may be horrible. Many new lenders might not have the experience necessary to manage it.

With more debt available than ever before, markets just feel different. The parties at the highest risk are different, too, creating a false sense of security for some players. It’s no longer deposits and banks that are at risk. Now the risk rests with institutional investors in the lending market. They should be better able to assess and manage risk. But too much leverage is never wise. Adding more debt onto the pile of debt never lowers risk.