This article was written in collaboration with Maxence Louvrier.
Direct lending is a subdivision of private debt, namely first lien loans made to middle market firms to generate positive returns. By working with such firms, private debt asset managers have the possibility to tailor flexible and creative financing vehicles that are specific to each deal.
Beginning in the 1990s but accelerating in the last 20 year, there has been a paradigm shift in the way economic actors raise capital through debt. Before this period, the market was a monopsony where commercial banks were the only buyers of such instruments. Because of the Global Financial Crises and the various regulations that followed it, many banks have decreased issuing middle market debt. However, firms still required capital to finance their hardship or development. Furthermore, central banks lowered their interest rates (in late 2019: ECB at 1%, Fed at 1.5%) meaning that private investors found it difficult to generate returns. Thus, the direct lending market allowed private investors to allocate their capital into firms that were struggling to borrow because of the competition.
In this framework, several opportunities have been identified within the private debt investment sphere, more specifically in the direct lending segment. Indeed, because of the appreciation in the value of many stocks and the decreased activity in M&As and LBOs, middle market firms are now estimated to sit on $80bn of dry powder globally to inject into other M&A ventures. Such ventures will require important amount of liquidity that, as seen before, banks are unable or unwilling to provide. Thus, investment opportunities will disproportionally be made available to private debt asset managers structuring financing opportunities. With this in mind, direct lending is the main type of opportunity generating strong returns to private investors. Especially with the pandemic, an increasing number of companies have seen their earnings or revenues drastically diverge from traditional models. An example of such a business structure would be a firm without earnings despite having relatively high level of revenue. These firms have potential to secure earnings in the future and have required levels of revenue to sustain debt, thus reducing the risk allocated with issuing such debt instruments. Furthermore, it is primarily private debt asset managers or non-bank lenders that can properly value these assets because of their specialized skillset.
Another sector in need of capital are the companies which have been hit by the pandemic. Most of these firms are producing goods and services designed for consumers who have seen their savings reach unprecedented high levels in OECD countries. These consumers are waiting to reinject this capital into the goods and services they used to consume before the pandemic, providing companies with revenue.
Also, loans used to finance LBOs or other various acquisitions will require capital from direct lending. Leveraged buyouts require capital that middle market firms have not access to within their books.
As seen last week, the 10Y German government bond has briefly rose above zero. This is a sign that some central banks are willing to raise their rates again to battle inflation and signal their trust into the economy.
Direct lending can offer a great protection against rising interest rates. Thanks to the way these loans are structured and their duration, interest rates have a diminished effect on their returns. Indeed, such loans do not decrease in value based on the floating line coupons increasing in line with reference rates. The maturity of these loans is also shorter than more traditional debt vehicles as they are underlined by all-cash coupons, as opposed to payment-in-kind coupons for high yield bonds.
This links to firms requiring loans to develop their business, as interest rates increase, they will have an increased attractiveness to non-bank lenders as the spread of rates required by the two types of financing institutions will decrease.
Direct lending, both in the EU and the US, has various opportunities in the coming decade to not only grow but to help mid-market firms to expand their activities. The pandemic has filtered some of the fruitless firms to leave a fertile soil for business expansion and strong positive returns for private investors.
