Direct lending: Uncovering the strategic edge

Sources: IMF, Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch (April 2024), KBRA, DLD Monthly Insights & Outlook U.S. Sponsored Deals (March 2024), Private Debt Investor, US BSL and US HY market size estimates as at 4Q23.

Direct lending continues to have a key role in servicing corporates

Despite the challenges, borrowers and direct lending managers have successfully managed the shift to a world of higher interest rates and heightened economic uncertainty. We believe direct lending is well positioned to continue to capture leveraged lending deal flow given the tailored solutions and structural advantages it may provide to borrowers in all market environments. Investors with a greater tolerance for illiquidity are able to take advantage of these structural benefits in exchange for better protections, active management, and additional return premia.

Direct lending provides execution certainty and tailored solutions to fuel M&A activity

Although M&A activity has been relatively subdued recently, the accumulation of middle-market private equity (PE) dry powder has reached record levels of over $US500 billion in 2023 (Figure 2). This capital reserve has positioned PE firms to seize opportunities as market conditions improve, in turn fuelling the pipeline of opportunities for leveraged lending as PE sponsors seek financing to complete buyouts. 

Figure 2: US PE middle-market AUM

Source: PitchBook | LCD, Data through March 31, 2024. Direct lending analysis is based on transactions covered by LCD News.

Figure 3: Global M&A activity

Sources: PitchBook | LCD Transactions covered by LCD News (March 31, 2024), Bloomberg, All pending and completed mergers and acquisitions (announced between January 1, 2010, and May 14, 2024).

We are already seeing this come through, as total middle-market loan issuance reached its highest level in 1Q24 since mid-2019 ($US15.4 billion versus $US15.0 billion), partly driven by the surge in leveraged buyout (LBO) issuance year-over-year.⁴

Figure 4: Quarterly total middle market loan issuance

Source: LevFin Insights, a Fitch Solutions company (June 2024).

With liquidity returning to the market, borrowers are once again being presented with the option of utilising the syndicated market for financing, which offers the advantages of lower interest costs and access to a broader capital base. However, financing through BSLs tends to be more standardised limiting borrowers’ ability to negotiate tailored terms. 

Direct lending financing offers a unique approach, typically negotiated bilaterally or as part of a small club, with a lender that the borrower already knows and trusts. This relationship allows direct lenders to provide flexible, customised solutions tailored specifically to the needs of private equity-backed companies. Unlike BSLs, which require a credit rating and can be slowed down by this process, direct lending moves swiftly without the need for ratings. This streamlined, personalised negotiation process gives borrowers greater deal certainty and faster execution speeds compared to public markets. As a result, we believe borrowers seeking more customisation and quicker execution will continue to prefer private markets over BSLs for their financing needs.

For larger borrowers focused on keeping interest costs down and accessing a greater pool of capital, rather than prioritised speed of execution and bespoke terms, the BSL market may be the appropriate choice. However, the direct lending market is catching up, especially with the resurgence of “jumbo” loans (i.e. loans that are larger than $US1 billion in size). In 1Q24, KBRA reported a staggering volume of $US16.8 billion in private jumbo loans, which is more than three times the issuance in 1Q23.² Winning mandates of this size, the direct lending market appears to be competing with bank syndications effectively. So while liquidity has recently returned and the syndicated loan market has seen increased activity, we foresee a continued trend towards larger borrowers opting to finance via private credit. This trend is driven by a growing recognition of the substantial benefits and extensive capital resources that direct lenders offer, which are increasingly seen as better aligned with their financing requirements. 

Refinancing and upsizes: Direct lending can act as a partner for both 

A second source of consistent deal flow in direct lending involves borrowers refinancing their current loan facilities. Refinancings are becoming an increasingly significant and reliable portion of the deal flow in the direct lending market, particularly in times of economic uncertainty when M&A activity may be reduced.

In 1Q24, refinancings contributed to $US17.5 billion of the overall direct lending transaction volume², amounting to 36% of the total (Figure 5). Notably, the refinancing of “jumbo” loans represented $US10.2 billion of this figure. This shift underscores a growing preference among borrowers to explore financing options in the direct lending market, avenues that were traditionally pursued through BSLs. 

We believe this trend of refinancing loans making up a greater proportion of deal flow is poised to continue. This expectation is fueled by a mix of market dynamics and the significant amount of middle-market direct lending debt approaching its maturity. With over $US100 billion in principal repayments scheduled for 2028 (Figure 6), borrowers are anticipated to actively seek refinancing opportunities to leverage favourable terms and extend loan maturities. 

Sources: KBRA, DLD Monthly Insights & Outlook (U.S. Sponsored Deals 1Q24/March Report).

We believe this is partly driven by the structural benefits of tailoring direct lending deals to align with PE strategies for growth. In “Buy and build” strategies, where PE sponsors use debt financing to grow a business organically or complete an add-on acquisition, direct lending plays a crucial role. These deals are typically structured to provide the necessary capital to strategically support these businesses through the different phases of growth. A deep understanding of a business’s growth plan can enhance deal flow through loan upsizes and refinancing within a private credit portfolio, benefitting direct lenders with established relationships. This has been a key focus for PE sponsors seeking financing while new buyout opportunities in the M&A market have been more subdued.

Different types of borrowers will access different types of financing

As highlighted, larger borrowers seeking large, cost-effective financing are likely to first look at the BSL market. However, large-cap direct lending deals are increasingly competing with BSL to finance large, sponsor-backed companies, which have substantial equity stakes and the financial resources to support their portfolio companies during challenging periods. The appeal of direct lending extends beyond just the large-cap sector, encompassing a diverse spectrum of borrowers. This includes middle-market and lower-middle-market companies, each with their unique, nuanced financing requirements and less standardised operations. Such companies often find the bespoke, tailor-made solutions offered by direct lenders particularly valuable. This versatility positions direct lenders as a powerful alternative, capable of meeting the distinct demands of a wide array of businesses.

This versatility of direct lending underscores its position as a formidable alternative to traditional financing routes, capable of accommodating the varied demands of businesses across the size spectrum. For investors, understanding the distinct opportunity sets and risk-return trade-offs presented by each lending solution is crucial. This knowledge allows them to navigate the complex financial landscape effectively, making informed decisions that align with their investment strategies and risk appetites. As the financial markets continue to evolve, the role of direct lending in offering competitive, flexible financing solutions is likely to grow, further solidifying its importance in the broader financing ecosystem. 

How can investors benefit from these structural differences? Unlocking the yield premia puzzle

Let’s now explore how the different characteristics of BSL, large-cap direct lending, middle-market direct lending, and lower-middle-market direct lending can create value for investors. Each market has a different return premia and type of borrower, but also has an alternative way to manage risk.

Structural protections and tailoring create a “complexity premia”

As mentioned, one of the reasons direct lending has experienced notable growth, is largely due to the flexibility it offers in structuring financing solutions. This customised approach allows lenders to establish financial maintenance covenants, bespoke protections, and other provisions unlikely to be found in the more rigid syndicated loan market. This translates into enhanced risk management and a “complexity premia”, providing investors with the potential for higher returns while offering borrowers the precise terms they need to succeed. 

We find that the level of tailoring and negotiation, and therefore complexity premia, associated with bespoke financing is often greater than loans issued on the syndicated market. Middle-market companies often have idiosyncratic financing needs and less standardised operations, therefore requiring more tailored solutions from lenders. In the lower-middle market, opportunities often demand highly detailed and specific terms due to their less established track records of cash flow and profitability. This raises concerns about their ability to service debt, making the risk higher. However, these challenges come with the potential for greater returns, attracting investors willing to engage in more intensive due diligence and stringent governance. By navigating these complexities, lenders can unlock significant value while ensuring that these companies receive the tailored support they need to thrive.

What is the illiquidity premia?

Direct lending diverges from BSLs in that it lacks a formal secondary market, primarily due to the private, bilateral nature of these hold-to-maturity investments. This characteristic means lenders are more committed to their investments for the long haul, often remaining engaged with the business post-deal completion. As a result, direct lenders typically command an illiquidity premium, which has historically ranged between 150-200 basis points above that of BSLs (Figure 7).

Figure 7: Illiquidity premia over time

Source: KBRA, DLD Monthly Insights & Outlook U.S. Sponsored Deals (March 2024).

For investors, recognising and setting an appropriate level of illiquidity tolerance within their strategic asset allocations is crucial. Similarly, direct lenders must exercise discernment in their investment choices. Engaging with a top-tier direct lending manager can provide access to high-caliber credits, featuring tailor-made structural protections. These elements combined have the potential to offer superior risk-adjusted returns compared to that of traditional BSL investments.

Where do we think the attractive opportunities are in leveraged loans right now?

Looking across the leveraged loan universe, where can investors find the most attractive opportunity? When considering the points discussed, and if an investor can tolerate some illiquidity, we think a broad mandate across the large-cap and middle-market opportunity set is worth exploring. This section of the market grants investors access to a broad opportunity set, competitive positioning for consistent deal flow, and attractive return premia with structural protections.

Figure 8: We believe having the ability to deploy across the large-cap and middle-market direct lending segments of the market offer the best risk-return balance and deployment opportunities.

The versatility to deploy capital across both middle-market and large-cap opportunities also allows lenders to adapt to market conditions and meet diverse borrower needs. However, it requires the investment manager to possess the expertise to navigate both segments effectively. Hence, it is beneficial to access this opportunity through managers with broad platforms and a track record that demonstrates an existing foothold in the market. Understanding the appropriate terms and pricing for each market segment ensures that lenders can offer competitive and tailored solutions, maximising returns while managing risks.

In an era marked by economic uncertainty and fluctuating market conditions, direct lending has emerged as an attractive alternative to BSLs. But the strength of direct lending lies in its ability to tailor solutions and maintain flexibility, offering significant advantages to business during challenging markets and attractive risk-adjusted returns for investors. 

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