Nov 2016 by Caroline Rasmussen
The surge of interest in direct lending may give rise to concerns that the opportunity is becoming saturated, as investors have directed $51.4 billion into North American-focused direct lending funds over the past three years.3 However, the supply-demand imbalance remains significant, favoring experienced lenders.
The surge of interest in direct lending may give rise to concerns that the opportunity is becoming saturated, as investors have directed $51.4 billion into North American-focused direct lending funds over the past three years.3 However, the supply-demand imbalance remains significant, favoring experienced lenders. As of the end of 2015, North American-focused private equity buyout firms held approximately $276 billion in dry powder.4 Assuming an average equity contribution of 40% per deal, the market is facing over $400 billion in loan demand from private equity sponsors. Combined with approximately $800 billion in looming leveraged loan market maturities through 2022, the overall demand for debt financing in North America over the next five to seven years is about $1.2 trillion.5 This large financing gap does not assume any growth in the underlying corporate market, or take into account any further decreases in the proportion of senior debt capital supplied by banks, which have been retrenching from the middle market due to regulatory changes.
Direct lending is the provision of debt financing on a private basis directly between a non-bank lender and the borrowing company. This type of lending is distinct from the traditional sources of debt capital for corporate borrowers, namely bank loans and syndicated public debt. Like syndicated leveraged loans (but unlike most high yield bonds), these private loans feature floating interest rates, positioning investors to benefit from any rise in rates while mitigating duration risk (the likelihood that rising interest rates will push security prices down).
Two tailwinds have been building for direct lending since 2009: (i) record low interest rates and (ii) the increasing regulation of banks. The former catalyzed a global search for yield, while the latter created a financing gap in several sectors, allowing non-bank lenders to jump in. Facing a persistent low rate environment, investors seeking to meet their historical return targets have had two options: take on more risk by moving down in credit quality to achieve higher yields, or look beyond traditional fixed income to newer strategies and trade some liquidity for high quality private credits.
Given the increased level of poor underwriting over the past several years, moving down the credit curve in high yield or otherwise is a high risk approach. The high yield bond default rate stood at 3.8% at the end of the first quarter, and is widely expected to accelerate.6 In addition to an increase in defaults, downgrade rating actions by S&P have increased dramatically in recent quarters, reaching a negative net 164 downgrades in the first quarter, indicating a significant drop in credit quality as perceived by S&P.7 Elevated levels of high yield and covenant-lite issuance in recent years, shown in Figure 3, suggest that low quality debt has already found its way into many portfolios.
In this environment, private direct lending has emerged as an attractive alternative. A key demand source for this type of financing has been the middle market, a sector traditionally served by banks and too small for syndicated buyers. To provide a sense of the scale of this opportunity, it is important to point out that the U.S. middle market generates $10+ trillion in annual revenue, accounts for a third of U.S. jobs across roughly 200,000 companies and, if measured as a country, would represent the third largest economy in the world.8 While the middle market segment is large and healthy, experiencing a 9% year-over-year increase in revenues and a 5% increase in earnings through Q1 2016, most investors have little or no exposure to this vast market.9
Private middle market loans can help investors address the fixed income conundrum, as they may carry premium yields to high yield bonds and large, syndicated leveraged loans. This yield premium is effectively an illiquidity premium, as investors require incremental return to compensate for the non-tradable nature of private loans. Direct lenders do not compete only on price, but some can also offer certainty of close and can serve as key, long-term credit providers to companies and private equity firms, effectively replacing the role that traditional banks used to play. By providing borrowers with assurance that their financing will close at the negotiated yield, which is appealing in today’s volatile markets, direct lenders can often command a premium for their loans.
In addition, banks have increasingly been unwilling to underwrite second lien debt at competitive rates, or even at all. By contrast, direct lenders have the flexibility to provide “unitranche” financing, a single loan combining both a first lien tranche and a second lien, or subordinated, tranche of debt (Figure 4). Unitranche loans are generally senior secured and can be viewed as providing both senior collateral protection as well as junior capital economics.
In addition to the lien priority offered by senior secured and unitranche loans, direct lenders typically insist on strong structural protections in their credit agreements, including both maintenance and incurrence covenants. As “buy and hold” investors, direct lenders perform their own due diligence on the borrowing company, which can often take six to eight weeks, and draft their own loan agreements, in contrast to syndicated buyers who rely largely on materials provided by the borrower’s underwriter and are often “term takers” – meaning they have little ability to negotiate terms or covenants.
A combination of floating rate yields and the downside protection offered by capital structure seniority, thorough due diligence, covenant protection and ongoing direct monitoring of company performance, has made private direct lending an increasingly popular strategy. Investors seeking yield without compromising on credit quality, or even simple diversification from the large corporate issue market, should consider allocating to middle market direct credits as part of their overall fixed income strategy.
(1) Preqin Press Release, May 5, 2016, Europe-Focused Direct Lending Fundraising Exceeds North America in 2015.
(2) Preqin 2016 Global Private Debt Report, May 2016.
(3) Preqin 2016 Global Private Debt Report, May 2016.
(4) Preqin, as of December 31, 2015; overall global buyout dry powder of $460bn, approximately 60% of which is North America focused.
(5) Leveraged loan market maturities S&P LCD as of August 31, 2015.
(6) Forbes, S&P Global: US High Yield Default Rate Expected to Hit 5.3% by March 2017, May 10, 2016, http://www.forbes.com/sites/spleverage/2016/05/10/sp-us-high-yield-default-rateexpected-to-hit-5-3-by-march-2017/#4ac9f7cd35d6.
(7) S&P Ratings Direct.
(8) National Center for the Middle Market: http://www.middlemarketcenter.org/infographics/2q- 2016-middle-market-indicator-infographic
(9) As measured by the Golub Altman Index, which tracks median revenue and earnings growth of more than 150 privately owned companies in the Golub Capital loan portfolio. Earnings defined as EBITDA.
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