Direct lending: A strategy for all weathers

More covenant headroom, slimmer credit spreads and a mountain of capital: that’s how many industry practitioners are assessing current market conditions – not just for the upper mid-market or the broadly syndicated market, but all segments of alternative credit.

But direct lending is still king among private debt strategies. Investors continue to embrace the strategy, as our annual LP survey, PDI Perspectives 2020, found once again. When asked about an array of credit strategies and investment plans in the coming year, a large portion of respondents, 29 percent, say they plan to deploy more capital into direct lending.

This follows the outcome of last year’s survey, when 38 percent of respondents anticipated an increase in direct lending allocations.

Varagon Capital Partners’ chief executive Walter Owens recently told PDI that two of its shareholders, insurers AIG and Aflac, share a common investment philosophy – one he described as “focused on preservation of capital by investing at the top of the capital structure of performing loans” during today’s “peak market conditions”.

First in line

Owens’ description gets to the core of direct lending’s value proposition: the strategy, associated with senior debt, comes with the inherent protection of being first in the repayment pecking order, not to mention an illiquidity premium that many investors believe makes up for the non-tradeable nature of the position.

The top risk cited by investors in the survey is a “possible recession in core markets”, with almost three-quarters saying that this worried them. In addition, more than six in 10 investors anticipate the US-China trade war as being potentially damaging to returns.

Responsibility for the broader economy and foreign policy do not fall within a credit manager’s job description, but they can control the risks being taken in each of their transactions.

Mid-market credits may remain somewhat insulated from several elements of these factors, given that their covenants remain stronger than those of the broadly syndicated market and that their business operations are largely North America-focused.

Still, risks remain as mid-market borrowers are not as naturally diversified as their larger counterparts and remain vulnerable to economic shocks. Portions of their own or their suppliers’ supply chains could also be located outside the US.

Prime position

Nevertheless, as we come to the end of the market cycle, direct lenders are sitting in a prime position. When credit markets freeze up, spreads will gap out and documents will become tighter. The relative simplicity of a direct lending deal compared with a broadly syndicated transaction gives direct lenders the upper hand in times of market volatility.

“Many are going to say, ‘I’m going to the direct lenders that have large hold sizes and I am going to take my execution and flex risk off the table,’” Fran Beyers, head of mid-market loan analysis at Refinitiv, told PDI at the end of 2019.

In addition, the factors that catalysed private debt’s rise are still in place: a low interest rate environment in which returns are generally meagre and investors are looking for yield.
Our findings are in line with other surveys, which show investors will continue to embrace private credit.

“Risks remain as mid-market borrowers are not as naturally diversified as their larger counterparts and remain vulnerable to economic shocks”

In a Natixis survey of insurance companies, 53 percent said they were increasingly turning to alternatives as a replacement for fixed income, while 44 percent anticipated increasing their exposure to private debt. And insurers are only one portion of the investor universe. The survey also revealed that 73 percent of respondents cited the low interest rate environment as one of their top portfolio risks and, consequently, 93 percent were worried about low returns.

With so many fundamentals still in direct lenders’ favour, it seems likely that only some sort of black swan event would drive investors away.