June 21, 2017 - On Tuesday, the LSTA hosted a webcast presentation, “It’s Always Better to Be Direct: A Guide to Direct Lending” presented by Latham & Watkins partners Andrew Fayé and Jane Summers. Middle market lending has traditionally been primarily through balance sheet banks, but in recent years, direct lenders have evolved from participants in club deals to leading deals for top tier sponsors. Unlike banks many direct lenders are unregulated and, at the very least, direct lenders are not affected by the Leveraged Lending Guidance. The direct lender’s business model is also different from that of arranging banks – the direct lender is relying on returns from the loan itself rather than fee income. Therefore, direct lenders tend to be more expensive but allow for certainty and speed of execution. Sponsors are also often able to get higher leverage than might be available with a bank. Within direct lending transactions, negotiations will vary depending on whether it is a bought deal, club deal or perhaps one with a significant hold and a partial syndication. In all these cases, however, there is less emphasis on a marketing period, limited and often no flex, and there is a greater focus on “underwritten terms” at the commitment stage because the ultimate holders of the loans are part of the conversation at origination. While direct lenders do expect and often get certain terms, including stronger underwriting terms, higher indicative pricing and a financial maintenance covenant, which may not be available in a syndicated bank-led deal, even direct lenders are starting to feel pressure on terms from sponsors. This pressure is leading to convergence in certain areas with those in large cap transactions. Prospective adjustments to EBITDA have been observed as well as run rate EBITDA cost savings adjustments. While there is still resistance, there have been examples of incurrence-based covenants as well as reclassification rights. This is not to say that direct lenders have lost their middle market DNA. For instance 4Q/monthly financials, possibly along with quarterly lender calls and/or MD&A, are still requested and deposit account control agreements are commonly part of the collateral package. There is continued focus on flexibility in baskets and earn-outs remain heavily negotiated. Also ,despite convergence with large cap terms, there continues to be focus on incremental facilities with direct lenders resistance to separate revolver tranches (favoring increases only) and direct lenders often require right of first offer to participate with new money lenders. We will see how sponsor pressure may affect terms in the coming months and whether the trend of convergence with large cap transactions continues.
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