Guest comment by William Brady of Paul Hastings
During the initial months of the covid outbreak, the direct lending market’s touted agility, creativity and flexibility was tested by its first encounter with a broad-based credit event since its development into a mature market post-global financial crisis. Via a host of bespoke solutions, direct lenders successfully navigated the downturn, stabilised their borrowers and avoided significant losses.
Direct lenders are now up against a new set of obstacles. Historically high inflation, rising interest rates, labour shortages, concerns about a global recession, global supply chain constraints, impacts from the war in Ukraine and increasing geopolitical tensions have created turbulence not seen in over 40 years.
Below are some of the biggest challenges direct lenders are facing.
Increased competition in an already competitive market
The proliferation of direct lending providers and the consistent increase in capital raised by direct lenders since the GFC created a lender-competitive, borrower-friendly market even during the height of the pandemic. On the heels of covid, the climate has been particularly cut-throat given dwindling investment opportunities and a growing number of direct lenders with dry powder.
The disparity in supply and demand has led some direct lenders to look for opportunities outside of their historic ‘norms’, including asset-based lending and structured finance products. It has also pushed upper-market direct lenders into larger deals traditionally reserved for the broadly syndicated market. These trends are expected to continue as banks curtail entry into new debt financings and seek shelter from the choppy markets. Nimble and innovative direct lenders will be the most competitive and best positioned to take advantage of new opportunities.
Deterioration of lender documentation protections
A by-product of the previously frothy market has been the gradual deterioration of lender protections in loan documentation. Borrower-friendly deal terms historically limited to broadly syndicated credit facilities initially drifted into direct lending loan documentation through the upper end of the market and then trickled down to the middle and lower markets.
The recent turn in the credit cycle has forced lenders to be more selective in the terms they provide and lenders have started to claw back borrower-friendly terms as they regain leverage. The introduction of ‘J-Crew’, ‘Chewy’ and ‘Envision’-type protections has helped close some of the well-known, legacy loopholes. However, there are newer, less-publicised loopholes that sponsors and borrowers may look to exploit. The current environment puts a premium on prioritising ‘must have’ (as opposed to ‘nice-to-have’) underwriting terms to remain competitive while providing downside protection.
Rough seas ahead
The current conditions, combined with the recent slowdown in capital raises and new deal activity, has already caused many direct lenders to redirect some of their attention and resources from sourcing new deals to servicing existing credits.
Some direct lenders may utilise the tools they used in the first months of the pandemic to give borrowers an opportunity to adjust, but for some deals that may not be enough. They must be proactive and create exit-mapping strategies for each deal and communicate regularly and strategically with certain parties of interest.
There is no ‘one-size-fits-all’ solution. Having an experienced team able to anticipate issues and create tailored solutions on a deal-by-deal basis will be key to direct lenders’ ability to successfully navigate the rough seas ahead.
William Brady is a partner and head of the alternative lender and private credit group at law firm Paul Hastings. Counsel Scott Heard and associate Jackson Cooper also contributed to this article