>> One of the most popular investment strategies for conservative pension and endowment investors could have serious risks that they misunderstand. I'm Lawrence Delevingne. I'm a hedge fund correspondent with Reuters in New York. And I've spent the last few months trying to understand direct lending, one of the hottest investment strategies in the country today.
Direct lending is an investment strategy whereby funds, which are either hedge funds or private equity funds, make loans to businesses that often can't get funding elsewhere. So they're willing to pay a high interest rates in return for money that can help keep their business afloat. After 2008, regulators were very concerned that banks were making loans that were too risky.
And so the banks have pulled back in who they're lending to. At the same time, institutional investors, like pensions and endowments, are hungry for any type of yield because bonds yield almost nothing, and stocks are expensive, etc. Direct lending can provide a steady stream of income for clients of the funds that do the strategy because they're lending to businesses who are paying high interest rates, and that produces a nice return when the money comes back.
Right now, direct lending has had an incredible run, producing month after month after month of gain for five or six years. The problem is the strategy hasn't been tested in a long time. The concern now is that a lot of the institutional investors who are piling into direct lending don't fully understand the risks.
All they see is the very smooth profits over the last five or six years. And they haven't quite thought through what could happen if a recession hits the US. There are a small group of sophisticated investors who initially loved direct lending after the financial crisis, and they're now starting to pull back.
They say that there are more risky loans being made. They say that returns are coming down. And really, they're just thinking ahead in two or three years, or whenever the next recession hits, what that will mean for the funds. At the end of the day, there are only so many struggling businesses that can actually pay debt at very high interest rates.
When a recession hits, a lot of those businesses could very well go under and that could mean losses and asset impairment, analog direct lending funds, in turn leading to not so safe results for the big institutional investors that are placing a lot of faith in them today.