Guest comment by Viral Patel

Every market disruption brings opportunities and challenges. Direct lending in Europe was born from the global financial crisis. More than a decade later, direct lending is thriving and encroaching on the territory given up by traditional leveraged finance banks due to regulatory influences.

Observers of direct lending often measure its success based on the size of transaction it can accomplish. Such lenders have become a regular go-to provider for up to £200 million ($240 million; €235 million) and even £500 million in some instances. A handful of mega-deals worth £1 billion-plus have also been completed. But do direct lenders really want to challenge the upper mid-market syndicated loan space (for our purposes defined as the £500 million – £1 billion-plus loan market)?

This is an ongoing debate, but there are fundamental differences between how direct lenders and syndicated loan market participants such as banks and collateralised loan obligations approach transactions.

There are drivers within the respective business models that guide the appetite for transactions. This includes how financing is structured around a transaction, the desired level of portfolio diversification or concentration levels, and structural factors such as retention of risk and the leverage deployed within funding vehicles. Simply put, direct lenders will have a more concentrated credit portfolio by sector and number of assets compared with a CLO fund or lending bank, which only typically retains a portion of the loan and seeks broader sector diversity.

Direct lenders typically target higher leverage in growth and defensible sectors. This approach helped them navigate their first real crisis – the 2020 pandemic. Participating banks and CLOs 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.

On the other hand, the direct lending market is private with no real indices to monitor peer group or sector performance. Relative value is less relevant as there is no established secondary market to evaluate and trade multiple opportunities simultaneously. The key selling point is to offer borrowers greater commercial flexibility and deal certainty to justify the premium charged (typically 1.5 to 2 percent) over the margins prevalent in the wider markets.

Financing differences

There are subtle but relevant differences in how debt finance is formed around a leveraged buyout transaction which informs suitability for each group. Within 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. There is narrow scope for access to borrowers, and most structures are covenant-lite with term sheets and loan agreements typically reviewed and rated by independent expert firms. Participants often draw on prior experience of liquid loan names or peer group companies to supplement decisions.

This approach is counteracted by a secondary market to trade loans (exit or top-up positions) and the ability to invest in much smaller lot sizes. Lenders can mitigate their risk to a degree while borrowers gain favourable commercial terms from the asymmetry in accessing a large pool of loan providers through an agent such as the underwriting bank. Access to financial information post-deal for portfolio monitoring is restricted in terms of frequency and granularity of reporting.

Direct lenders’ approach is contrary to the above. They 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.

Just as lenders look to find opportunities in a market with structural changes, borrowers also quickly follow suit to seek better terms from a burgeoning direct lending market. One feature is the covenant-lite unitranche loan which levels up the direct lending market with the syndicated loan markets. However, this remains a highly divisive approach and one that has not fully permeated the direct lending space. The ability to gain further share from syndicated loan markets in the medium to long term could depend on it.

Instances where there have been large direct lending deals are still low in proportion to overall market volumes and typically focused on specific opportunities where lenders have a differentiated angle in terms of familiarity with the borrower (existing or prior lending relationship), strong private equity sponsor relationships and prior positive sector experience. There also appears to be some correlation between private equity-backed direct lenders and a growing appetite for larger deals when compared to standalone direct lending funds.

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. While direct lending funds are getting bigger in size as more institutional investors gravitate towards private markets, the current credit outlook points to caution in both transaction volumes and the strategy of increasing exposure through larger loan investments. Direct lending funds traditionally increase their exposure to borrowers incrementally by funding add-on acquisitions commonly known as buy-and-build strategies.

Dislocation

Current dislocation in the credit markets has created some yield parity between direct lenders and syndicated loan markets. This is primarily because the original issue discount offered to syndicated loan market participants to accept deals is at levels reflective of a crisis, thereby eroding the premium charged by direct lending funds. This provides some incentive for borrowers to consider direct lending if they were previously deterred by the financial cost. But the window of this dislocation is hard to predict.

There are other benefits within the syndicated loan markets for borrowers to be able to quickly issue event-driven top-up loans and access a wider pool of liquidity. This process could be more challenging for borrowers in the direct lending markets, especially if the borrower is not performing to plan. Syndicated loan market borrowers can also carry other forms of debt such as unsecured bonds, which is not typically the case in structures offered by direct lenders.

In the near term, borrowers and sponsors may be tempted to consider direct lenders to bypass syndicated loan market volatility. However, when these markets eventually stabilise and direct lenders adjust their margin expectations upwards to factor in rising rates, borrowers are likely to fall back on syndicated loan markets for several reasons.

Both CLOs and direct lenders have near record levels of funding and provide borrowers with good optionality. US direct lenders are increasingly looking to access European markets and this is providing more firepower for funding larger deals, creating a shift towards covenant-lite unitranche structures and club formations within direct lenders.

But the key question remains how far direct lenders and their investors are willing to go to compete with syndicated loan markets across various dimensions of a deal and, ultimately, the take-up of such loans based on the perceived advantages and disadvantages in the eyes of the borrower and sponsors.

The overall deal-making environment appears uncertain compared to 2021 and may not provide the prime conditions for direct lenders to materially shift their risk appetite.

Viral Patel is a managing director at Prime Lead Partners, a London-based strategic consulting and debt advisory firm