Moody's: The rise of shadow banking continues as direct lending is set for strong growth in 2015

Direct lending is set to become an established asset class in Europe, with robust growth estimates over the next 12 months, says Moody's Investors Service. In a report summarising the views of keynote speakers and panelists at Moody's 2015 Asset Management Conference in London, the rating agency highlights that conditions for such growth has been aided by the regulatory environment and bank disintermediation following the 2008-09 financial crisis. Moody's also says that asset managers will continue to innovate and provide creative solutions for borrowers in the changed regulatory landscape.

"We expect the rise of shadow banking to continue in 2015 and beyond. Banks' appetite for certain forms of lending remains low, and direct lending by private debt funds will fill that gap in Europe. As bank regulation has become more stringent in recent years, we have seen risk moving away from the banks to other parts of the financial system", says Soo Shin-Kobberstad, a VP-Senior Analyst at Moody's.

The conference brought together key players in the industry. Citing estimates of EUR15 billion growth in direct lending funds in the Deloitte Alternative Lender Deal Tracker (published December 2014), Moody's forecasts that the growing number of private debt funds will prompt an increase in fund-raising that will reach critical mass in 2015. Conference panelists indicated that returns achieved on those funds focusing on senior loans are around 8%.

Panelists generally agreed that growth in direct lending was driven partly by new regulatory initiatives that encourage investors to support growth in the real economy. However, Moody's highlights that the regulatory and government policy measures to promote direct lending to small and medium-sized enterprises (such as guarantees provided to certain funds and programmes) could distort risks and market clearing prices for loans. The rating agency also observes that the direct lending market has not been tested through several credit cycles.

Panelists also pointed out that newer entrants into the European direct lending market, eager to build business, could push margins on loans lower than the underlying risks might justify -- leading to a deterioration in credit standards.

Nonetheless, Moody's says asset managers of direct lending funds have, thus far, demonstrated discipline in credit selection and in pricing to deliver appropriate risk-adjusted returns for investors.

Overall, Moody's notes that, from an investor's perspective, direct lending funds offer higher risk-adjusted returns and generally lower volatility compared to traditional bonds and equities, whilst from a borrower's perspective, direct lending provides two key advantages: (1) borrowers have the certainty of closing since funds hold most deals and do not syndicate them; and (2) asset managers work closely with borrowers through their business cycles by providing bespoke terms and flexible capital beyond traditional bank parameters.