Family Offices Exploring Direct Lending

High net worth individuals and family offices, in search of autonomy and flexibility, are increasingly managing their wealth internally rather than placing their money in funds managed by third parties. The collective size of family offices has surpassed that of hedge funds in the United States. Bloomberg estimates that hedge funds are currently managing approximately $2.9 trillion, while family offices control between $3-4 trillion.

However, despite the incredible size of family offices, investors are unable to attain their desired returns. While these investors have high expectations, realized returns from traditional investment opportunities have consistently fallen short. According to Legg-Mason’s annual Global Investment Survey, income investors seek an average rate of return of 8.64%, but municipal bonds, US treasuries, and corporate bonds struggle to offer returns at all. Dividend yields are also low, with the Dow 30 returning only 2.75%. This is signaling the increased need for non-traditional portfolios. Family offices have the opportunity to grow their returns by exploring other options.
Investing in alternative credit offers a solution to this problem. Specifically, direct lending opportunities in the middle market have yielded attractive returns in the current low-yield environment. Middle market loans have the potential to generate high yields that reflect a significant premium to public market alternatives.

The higher yield of middle market lending is not attributable to higher risk profiles. In fact, these loans default less than 4% of the time, and in the case of default, the loans recover 80-90% of their value. These investment opportunities take advantage of the liquidity premium, which is defined as the additional return required by investors when an investment cannot be easily exchanged for cash for its fair market value. The stock market and traditional bond market are classified as highly liquid because of the ease of conversion to cash. On the other hand, venture capital, private equity, and distressed debt investing locks in investors for many years and are considered illiquid. If family offices take a closer look at the lending opportunities in the lower middle market and middle market, they can take advantage of higher returns without necessarily taking on riskier investments.

Because of the unique opportunity that middle market lending provides, there are several key characteristics to take note of:
• Periodic Income distributions
• Floating-rate interest based on LIBOR
• Target loan yield of 8-14%

Given the continued rise of family offices worldwide, the need to explore alternative investing options has never been more important. In the current low-yield economy, the emergence of middle market lending has become a viable option for these family offices, and the liquidity premium boosts returns without sacrificing risk.