As pressure grows on banks to restart lending activities, buyers are warning the window of opportunity on private lending funds may soon be closing, writes Julia Rampen.

Fund selectors buying into private lending funds are at odds over whether European Central Bank (ECB) action will bring to an end an ‘Indian summer’ for the asset class.

Private lending funds have enjoyed a surge in interest as investors seeking higher yields at lower volatility take advantage of vehicles filling the gap. These have been created by banks’ increased unwillingness to provide companies with credit post-crisis.

Typically offering investors yields in excess of 5%, the funds have stepped in to meet the needs of property developers, businesses, and others looking for loans, providing funding such as "mezzanine lending" to top up a company’s loan to value ratio before it applies for bank financing.

However, as pressure grows on banks to restart lending activities, some buyers have warned this is the ‘Indian summer’ for yield, before the asset class becomes more ‘equity-like’ and returns begin to drop.

According to figures from Prospect Wealth, agricultural loans fund Prestige Alternative Finance offers an average return of 6% per annum, with volatility of 0.4% in the eight years since inception.

By contrast, the IPD commercial property index has returned 4%, with average volatility of 5.4% over the same period.

The FTSE 100 has produced a total return of 5.8% per annum over that period, with volatility of 16%, Prospect Wealth said.

Gilts have returned 6%, with 6% volatility, and the investment grade corporate bond iBoxx index has delivered 2.7%, with volatility of 9%.

Prospect Wealth investment manager Matthew Hunt said the last five years have been a "golden age" for non-bank lending funds.

The managers of the Ruffer investment company said strategies such as the Beechbrook Mezzanine fund have paid off for the portfolio since 2009.

However, Hunt suggested the window of opportunity is closing. "Now we are in the Indian summer. We are seeing more funds launch, but it is happening at a time when banks are lending again, so margins may be lower from here.

"The opportunities are still there but, in future, rather than 5%-8%, returns may be more like 3%-5%."

Stanhope Capital CIO Jonathan Bell (pictured) agreed policies such as the ECB’s decision to provide cheaper funding for lending may see banks return to the market: "It will become tougher. The mezzanine space will become more equity-like and returns will be lower," he said.

However, Bell continues to add to private credit, including mezzanine lending funds, given the good level of yield still available.

He contrasted the 8% yield on offer from BlueBay Asset Management’s private lending fund with the 2.5% yield on the MSCI World index (as at 15 June), the 2.75% yield on 10-year gilts, and the 5% yield on high yield bonds.

Will yields fall back, as Hunt predicts? Despite looser monetary policy from the ECB (see box), the environment for lending remains tricky for many European banks.

This is because of factors including more stringent capital constraints – not least the ECB’s own Asset Quality Review (AQR) and subsequent stress tests. Accordingly, some managers see little in the way of renewed competition for lending funds.

Smith & Williamson multi-manager James Burns said European bank deleveraging "is only just getting going".

Burns has been adding to the Real Estate Credit Investors lending fund, which offers a 7% yield.

This is a typical example of a lending fund focusing on the European market, according to Burns.

"The banks were the only dealers in these things. Take property. In Europe and the UK, banks dominated this lending market.

"In the US, banks were important, but so were insurance companies and specialist lenders. A lot of this is as a result of the banks deleveraging. In Europe, this is only getting going."

Disruption in the banking sector is also a theme being played by the Henderson Value trust.

As well as Real Estate Credit Investments, the fund holds Chenavari Capital Solutions, which takes responsibility for a portion of banks’ credit risk in return for premiums.

Co-manager James de Bunsen contrasts the opportunity with that of lending directly. While a 5-year Tesco bond pays 3.1%, a fund investing in loans to a property owned by Tesco may be a similar credit risk but offer a much higher yield: "You could safely say at least twice that rate," he noted.