January 30, 2020 - We knew the direct lending market is hot – and the 650 LSTA members that attended Wednesday’s “Direct Lending and the Syndicated Loan Market” webcast, featuring experts from Golub, KKR, OwlRock and Davis Polk, confirmed it! Wednesday’s webcast was “Part 1”, which provided an introduction to Direct Lending. Part 2, which takes place on February 6th, will delve into differences between direct lending and syndicated lending. So what did we learn?
We started with definitions and sizing. Panelists defined direct lending as 1) private debt to leveraged companies, 2) provided by unregulated institutions, 3) that is meant to be “non-broadly” syndicated, and 4) that is done in a “loan to hold” relationship. Historically these have been middle market loans – say for companies of $50 million EBITDA and below – but company and deal sizes have increased. A number of recent clubbed direct loans – such as MRI Software, Integrity Marketing and ION/Acuris – have approached or topped $1 billion in deal size. From a market size perspective, Slide 5 suggests that outstanding private direct loans have grown from $400 billion in 2013 to roughly $700 billion in late 2018. (We’ve also heard back-of-the envelope calculations ranging from $400 billion to $1.2 trillion.)
So direct lending has grown quickly. But why? Panelists noted three intersecting factors: i) demand for debt from PE, ii) supply of debt capital from institutional investors, and iii) some cannibalization of traditional club bank lending and the Broadly Syndicated Loan (BSL) market. First, PE has been on a fundraising jag; there are more specialist and mid-market funds, they are buying companies and have a strong demand for debt. Second, historically, direct lending was not a part of institutional allocation strategies. Now, institutional investors have allocations to direct lending as an asset class, opening a significant flow of credit. Third, banks have moved away from direct lending, due, in part, to regulatory pressures. And fourth, sometimes borrowers simply prefer direct loans to syndicated institutional credits.
So, why are direct loans attractive to borrowers and non-bank lenders? Panelists noted that borrowers like the ease of execution, the bespoke nature of the transactions, the fact that they can be done quickly (with certainty and without price flex), and the knowledge that deals won’t be held hostage to technical slumps in the BSL market. Many are done as unitranche facilities, which provide all the debt needs of the borrower in one fell swoop. In addition, many direct lenders also offer delayed draw facilities for borrowers seeking rapid growth or add-on acquisitions. Because there are few lenders, direct loans don’t have to be rated – and thus are not limited by rating agency or CLO criteria constraints. And, because direct loans do not have to conform with rating agency criteria, leverage may be “optically” higher, but still appropriate for the situation. In addition, borrowers can keep confidential information confidential. Finally, with no bank meeting and no ratings process, origination fees may be lower, panelists said.
So why do lenders like direct lending? Because there are a limited number of lenders in a deal, each lender has a material say in the deal, the leverage, the covenants and the documentation. There is an ongoing, long-term relationship with the company and management directly, which theoretically reduces the zero-sum-gaming we frequently see. On top of that – or because of that – yields and returns on direct loans tend to be higher and more stable than the BSL market (though slide 13’s 2008/2009 return data suggests some stability may just be the lack of mark-to-market volatility). So now that we have the basics, we’ll dig into the comps to the BSL Market in the Second Direct Lending Webcast installment on February 6th! We hope to see you there!