Direct lenders have started to encroach on syndicated loan territory, but is it a sustainable development?
What is direct lending, and how did it originate in Europe?
Direct lending in the European leveraged finance market refers to the practice of debt funds and other non-bank entities providing debt financing directly to companies, rather than going through traditional bank intermediaries. This form of lending has grown in popularity over the past decade, particularly since the GFC of 2008, due to regulatory influences that have limited the ability of banks to provide certain type of loans and increased appetite from financial institutions (insurers and pension funds) for so-called alternative assets. Direct loans can offer borrowers greater flexibility since the terms can be more customized than traditional bank loans, while also providing investors with attractive returns and portfolio diversification.
What are the differences between direct lenders and syndicated loan market participants?
There are several differences between the two. Direct lenders have a more concentrated credit portfolio by sector and number of assets compared with a collateralised loan obligation (CLO) fund or lending bank, which only typically retains a portion of the loan and seeks broader sector diversity. Direct lenders also typically target higher leverage in growth and defensible sectors. Syndicated loan market participants, on the other hand, are open to considering cyclical and lower-growth sectors such as consumer, industrials and manufacturing to achieve greater diversification. They also take cues from other adjacent markets such as high-yield bonds and have access to various indices for price, relative value and risk sentiment along with guidance from loan ratings agencies such as Fitch, Moody’s and S&P.
How is debt finance structured around a leveraged buyout transaction in syndicated markets, and how does it compare to the direct lending market?
In syndicated markets, underwriting banks are the key drivers of loan origination and the respective terms offered to borrowers. Potential participants have a short window of typically two to three weeks from start to finish to fund a new transaction with access to due diligence often coinciding closely with commitment dates. Direct lenders, on the other hand, are focused on broad access to borrowers and due diligence on company fundamentals as well as on documentation, given these deals are most likely conducted on a bilateral basis or in certain instances as part of a small club of direct lenders. The take-and-hold exposure to each company is also multiple times higher than that gained by syndicated lenders, prompting a commensurate approach to assessing pre-deal investment risk and post-deal portfolio management.
What are covenant-lite unitranche loans, and how do they compare to syndicated loans?
Covenant-lite unitranche loans are a familiar feature of the direct lending market. They are loans that are typically issued to fund leveraged buyouts and combine both senior and subordinated debt into a single tranche with a single interest rate, allowing for a simpler capital structure. They are called “covenant-lite” because they have fewer restrictions or “covenants” attached to them compared to traditional syndicated loans. This approach levels up the direct lending market with the syndicated loan markets.
What segment of the market do direct lenders focus on?
Direct lenders have become regular go-to provider for loans up to €250 million and even, in some cases, €500 million. Still, relative share of larger direct lending deals is still low compared to the overall market. There have only been a handful of mega-deals (> €1 billion) so far. Majority of larger deals are done by credit funds that are backed by private equity firms. Standalone direct lending funds typically focus on the traditional direct lending segment.
Do you expect direct lenders to challenge the upper mid-market syndicated loan space?
There is an ongoing debate on whether direct lenders want to challenge the upper mid-market syndicated loan space, defined as the €500 million – €1 billion-plus loan market. However, there are fundamental differences between how direct lenders and syndicated loan market participants such as banks and CLOs approach transactions. While direct lenders have completed a handful of mega-deals, there are several macroeconomic headwinds today affecting both the operating model and the financial results of borrowers, which is likely to prompt further caution by direct lenders when assessing larger opportunities.
In the near term, borrowers and sponsors may be tempted to consider direct lenders to bypass syndicated loan market volatility. However, when markets eventually stabilise and direct lenders adjust their pricing expectations, borrowers are likely to fall back on syndicated loan markets. The overall deal-making environment in 2023 still appears uncertain and I do not expect that it will provide prime conditions for direct lenders to materially shift their risk appetite.
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