April 16, 2021 - As banks retreated from their lending businesses after the global financial crisis in 2008, small and middle market companies have increasingly looked toward nonbank lenders to finance their business needs.   And because their direct lending strategies are characterized by flexibility, the future looks very bright for non-bank lenders to maintain their ever-expanding market share.   At the third session of our Operations Conference, Ryan Morick (AlterDomus), Rob Healey (CSAM) and Jeremiah Loeffler (Crestline Investors) noted that while flexibility may drive their business, standardization would be fantastic. 

Buy-side institutions, accustomed to buying leveraged loans, are used to processing information, not generating it.   Looking at deals is very time consuming.  They have now entered a market where they originate, negotiate, underwrite, draft documents, serve as agent for notices and payments, etc.    Therefore, care needs to be taken in selecting third party providers.   The most efficiency is gained by finding one who can handle the portfolio, agency and fund administration roles.  

Due to a high level of manual intervention, direct lending is a complicated process.   Procedures must be followed but one must be adaptable to changes not thought of at the onset of the deal.   Time must be built into the transaction to affect the adjustments with additional steps to make the process flow accurately and efficiently.   Everyone who is involved must understand the transaction front to back.

The right custodian to handle this product is different from that of the syndicated loan product.   Under the Custody Rule, a single bank account with the individual Borrower’s assets, not co-mingled with the assets of any other Borrower, must be established with a qualified Custodian to include only payments from the Credit Agreement.  Establishing an arrangement with an independent public accountant to perform annual surprise audits can make compliance with the Custody Rule expensive and challenging. 

For many Borrowers it is the first time that they are going through this process.   It is essential to communicate with them from the beginning to the end, realizing that there is no uniformity in these transactions.  There is a stark contrast with the leveraged market in that with direct lending there are always nuances, nothing ever looks quite the same, and with that come variations in how a credit agreement is written, how the loan is processed and funded through an escrow or directly and why certain tasks are done.      

If the LIBOR transition is met with daily rates, this will have a big impact on how rates are communicated to Borrowers and lenders.  A central market data warehouse that would allow them to check rates and accruals, would be preferred to notices. Tools used by corporate treasurers do not manage daily rates well, so complications are anticipated.   Will the lower end of the leverage loan market impact direct lending or will direct lending affect the leverage loan market?    As a clear takeaway, our panelists stated that while the direct lending market is admittedly bespoke, standardization would be fantastic – standardization is important.   They suggested that the LSTA create a committee to discuss ways to bring standardization and automation to the private credit market.  Sounds like a very good idea – so stay tuned!

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