Over the past six months we have conducted close to 75 calls with direct lending fund managers to check on how things are going. The number one theme that we have heard time and again is that it is time to educate the Asset Allocator community about the direct lending asset class, which is one of the most compelling segments within the private credit spectrum.
The Asset Allocator community consists of Pension Funds, Insurance Companies, Ultra High Net Worth Family Offices, Sovereign Wealth Funds, Endowments, and Foundations. This community is in the business of allocating capital to various market segments most often through specialty fund managers. This market often works closely with ‘Gatekeepers,’ which include Discretionary fund of funds and Non-Discretionary Investment Consultants.
Why Gatekeepers Matter
Here is why the Gatekeepers play such a critical role. Let’s say you are the President of a mid-sized college with an endowment of about $500 million in assets. In addition to providing a top notch education for your students, your job is also to raise money for your endowment and to invest that endowment to achieve a targeted return while minimizing risk. A portion of the investment earnings will be used to fund the operations of the college offsetting the cost of tuition. Every dollar matters. Instead of hiring a full time staff, you rely on a group of College Trustees to meet on a quarterly basis to review the performance of the endowment and reallocate capital when appropriate. This is a volunteer staff that meets only four times per year.
The Role of the Gatekeeper
This is where the Gatekeeper comes in. A non-discretionary investment consultant is hired to advise the Board of Trustees on their asset allocation strategy. This consultant is paid a fee to provide unbiased advice. The consultant does not have any control over the investments (non-discretionary) and they are not allowed to take a fee from the managers so their incentive is to purely provide the best advice possible to their clients. In this case, a consultant advises that the board to consider reallocating a portion of their endowment to a new asset class, the online direct lending category, and they give their pitch as to why it is a good fit. The investment consultant then recommends 3-4 managers that have been vetted and fit the profile. The trustees will interview those managers at the board meeting and pick their favorite 1-2 managers for their portfolio. The consultant has performed all of the background due diligence so that the board can interview and decide.
Now here is how it really works. A prominent member of the board of trustees has a relationship with a direct lending fund manager. At the quarterly meeting this trustee makes the recommendation to the board and to the Gatekeeper that the endowment should allocate to this new asset class and the Gatekeeper should go do some research and come back next quarter with an overview of the category and a few suggestions for managers, including this one that the trustee knows. The Gatekeeper does their homework and comes back next quarter with a full review and recommendation. If the board decides to allocate, the Gatekeeper feels a strong sense of accomplishment for opening a new asset class and providing value. They have also completed this valuable due diligence that can be applied to other clients.
The Gatekeeper talks to a few other consultants at the firm and they find out that a similar discussion is taking place at other endowments. In fact, they hear that one of the major endowments is also conducting due diligence on the asset class. This gets the Gatekeeper really excited. This new idea seems to have legs. The group of consultants band together and decided to collectively write a firm wide research report on the direct lending category. They go deep. The research team is tasked with interviewing as many direct lending managers as possible and to build a matrix to compare and contrast strategies across the industry. The research is deployed firm wide and to all clients. The consultants are now armed with the data to introduce this new asset class to all of their clients.
Now the tables have turned for the investment manager. They may go visit the consultant as part of the due diligence for one client but they get surprised when five consultants show up at the due diligence meeting and each consultant has three or four endowments, foundations, pension funds, and UHNW families that have an interest in the category and in the manager. The floodgates open and the money for the new asset class is unlocked.
Why Now?
Ok, so this is the ideal scenario that every fund manager dreams about. The floodgates open and the consultant adds their fund to the short list of “institutional quality” fund managers to be considered when making an allocation to the category. So how can we make this happen and why now?
We think that the timing is right to get the Gatekeepers involved. Our industry has several fund managers that have crossed $1b in AUM with a larger number in the $250m-$1b range. The track records are approaching 3-5 years and the teams are investing in the internal compliance and back office infrastructure to accommodate institutional demands. Most importantly, the collective track records for the industry are very promising, indicated high yields, relatively low volatility, relatively low correlation to the equity and bond markets, and short duration.
With so many fund managers in the market, the Gatekeepers are beginning to receive 3,4,5 or more PPMs from various managers. We believe that the Gatekeepers need to scale up their knowledge base very soon so they can stay ahead of the curve. Those Trustees are going to start asking questions soon and the Gatekeepers should be ready with an action plan.
What Can We Collectively Do?
The Lend Academy and LendIt teams want to help as many managers as possible and we are asking for your help. All Asset Allocators are invited to LendIt USA 2017 for free. If you know any Asset Allocators, please introduce them to us so that we can give them a free ticket. Alternatively, we can provide you with a private code to share with your investors so that you can register them yourself. We believe that our industry will benefit if we can convince the Asset Allocators to take a 2-day immersion into our industry at LendIt. Furthermore, we are planning a special event on the evening of Day 1 of LendIt for the Asset Allocators and hosted by the fund managers. If you want to get involved please reach out to [email protected].
Conclusion
The direct lending asset class was formerly monopolized by banks and credit card companies but in the past few years this asset class has been cracked opened and it is now available more widely, including to Asset Allocators. The fund manager track records and the operational infrastructure layer of the industry has developed to the point where the institutional market is on the horizon. It is time to educate the Gatekeepers so that they are prepared to have the conversation with their clients about why it is smart to allocate to the direct lending category.
Jason spent three years early in his career as a research associate covering alternative assets at Cambridge Associates, one of the leading investment consultants in the industry.
