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US direct lenders modify fee structures as private lending loses luster

David Brooke and Andrew Hedlund

By David Brooke and Andrew Hedlund

NEW YORK, July 28 (LPC) - Direct lenders in the United States are modifying fund fee structures to compete for limited investor dollars in a lackluster—yet competitive—fundraising environment for private debt.

Investors are taking a step back from illiquid opportunities as businesses worldwide grapple with the global health crisis brought on by the Covid-19 pandemic. After a decade-long expansion, private debt fund commitments, which, unlike shares, cannot be redeemed easily, have seen fundraising numbers drop as a result.

Credit managers are no longer capturing the fee income they were in years past due in part to a 70% decline in private equity-backed middle market deal activity in the second quarter compared to the first. The uncertainty of the pandemic’s course on the US economy has seen a drop in fundraising for many firms.

"Some investors, such as pension funds and endowments, have been facing liquidity constraints. As a result, they are increasingly holding off on investing in private funds because of the need for regular cash flow," said Michael Ewald, global head of private credit at Bain Capital Credit.

Direct lending funds raised US$9bn in the second quarter of 2020, according to research firm Preqin, a decrease from US$11.9bn over the same time last year.

Downward pressure on fees has only worsened in recent days. The proliferation of private credit and direct lenders in the last four years has resulted in an intense race among new and existing players to raise capital causing further fee compression.

In response to the challenges, funds are modifying fee structures to entice investors.

Asset manager Barings, for instance, launched a private business development company (BDC), a specific type of credit fund, with a 12.5% incentive fee, lower than competitors' typical 17.5% or 20%, along with a hurdle rate tied to Libor, a key benchmark interest rate.

A typical private debt fee structure has a management fee of 1.5%-2% and an incentive fee ranging between 15%-20% paid out over a 7%-8% hurdle, according to industry analysts.

The incentive fee allows managers to participate in investment profits, while the hurdle rate ensures investors earn a specific amount before the manager takes any profits.

An incentive fee structure that is pegged to Libor, which is a floating interest rate, takes away the incentive to invest in riskier assets, when Libor is low, as it is currently.

"By having a structure where the incentive fee has a Libor component in it, there is no motivation to chase risk to get your incentive fee by chasing higher-yielding assets," said Robert Dodd, a BDC analyst at Raymond James Securities.

In general, investments with a higher yield carry more risk than lower-yielding positions.

The Barings vehicle also charges a 15bp management fee, which the credit firm receives for overseeing the capital. That figure is a fraction of the 150bp BDC industry standard.

At the peak of the US shutdown, many listed BDCs reported pressure on first-quarter earnings. As a result, Gladstone Capital Corp, a publicly traded BDC, increased its hurdle rate to 8% from 7%, which took effect April 1. That move meant investors would receive a higher return before the BDC management earned a share of the profits.

PAYING LESS

Direct lenders have lowered their fees since a high point in 2015, according to Preqin data, to adapt to the intense competition in the US middle market.

The average management fee this year is 1.45%, according to the data. Average management fees, though higher than this year, have been lower than the 1.8% peak average recorded in 2015.

Many fund managers raising BDCs will keep a vehicle private, only allowing institutional investors to buy into the fund, before conducting an initial public offering (IPO). During that ramp-up period, lenders traditionally offer institutional investors a lower management fee and remove any incentive fee.

Owl Rock Capital Corp charged a 75bp management fee with no incentive fee before going public last year. Now public, the BDC charges a 17.5% incentive fee over a 6% hurdle rate and a 1.5% management fee.

Owl Rock offered fee waivers for the five quarters following the IPO, allowing any investors that committed money to the BDC at rock-bottom fees to withdraw their money to avoid the higher fees, Dodd said.

An Owl Rock spokesperson declined to comment. Spokespeople for Barings and Gladstone did not respond to requests for comment. (Reported by David Brooke and Andrew Hedlund. Edited by Michelle Sierra, Kristen Haunss and Paula Schaap.)