1. Continued growth of direct lenders in the US
With the chance of a Democratic House majority and the logistical obstacles that come with it, banks may face a more difficult path back to mid-market lending than initially anticipated under a Trump administration. A probability model overseen by FiveThirtyEight, a US news site run by data guru Nate Silver, currently puts the Democrats’ chance of taking back the House at over 80 percent.
A Democratic majority would certainly limit any deregulatory agenda that banks might have benefitted from in a continued Republican-controlled Congress. In addition, the regulation process in the US can be tenuous, offering a fair amount of uncertainty, and banks would need to re-establish their mid-market lending desks.
Managers often cite the flexibility of direct lending loans as an attractive opportunity for private equity sponsors, and if it continues to resonate with those firms, direct lenders will become further entrenched as a viable, and maybe even preferred, source for financing private equity deals.
“We believe leverage lending will continue to shift to asset managers that can deliver a more flexible product offering, superior coverage of sponsors and certainty of execution to sponsors,” says Walter Owens, chief executive of Varagon Capital Partners. “As a result, direct lead lending for performing sponsor leveraged loans will become a separate asset class within alternative credit with significant demand by a broad base of institutional investors.”
While the private credit industry has yet to face an economic downturn, let alone a crisis, as an established asset class, available data often pointed to by alternative lenders paints a positive picture.
In a Hamilton Lane white paper published earlier this year, the firm’s global head of credit investments, Drew Schardt, argues returns have outperformed other alternative asset classes in a rising interest rate environment. Should the asset class perform positively through the next downturn, it would be another feather in direct lenders’ cap and result in continued investor interest.
2. Rising rates will finally impact credit underwriting
LIBOR remained near 0 percent for many years but has gradually risen over the past two, resulting in higher interest rate floors, although spreads have compressed.
“Interest rates have increased and spreads have narrowed over the same period,” says Richard Byrne, president of Benefit Street Partners. “Going forward we think there is a good chance that if rates go incrementally higher then spreads could widen as well to maintain some sort of proportion to the base rate.
“[The fate of] the credits themselves depends on how much rates go up. An extra 100-200 basis points in increasing interest rates is not going to be awful for most companies. It’s when you get out of that range that it gets more difficult to assess.”
The boat will eventually be rocked though. Higher borrowing costs might result in a larger disparity between businesses – those in a financial position able to meet the increased cost of debt and those unable to do so – or the “shaking out [of] kick-the-can credits”, as one source puts it.
As portfolio companies deviate from the straight and narrow, looser documents could delay restructurings, causing real value to slip away from the lenders. Plenty of alternative lenders profess to have tight documents, but only time will tell whether managers negotiated a sound, or otherwise passable, credit agreement.
3. Disparity between the haves and have-nots
This is a trend PDI outlined last year. It has certainly played out, and we are predicting more. As more limited partners have entered the space, many of the largest firms have been the beneficiaries with new investors often going with “household names”.
Ares Management’s Ares Capital Europe IV is a recent example of this phenomenon. The €6.5 billion vehicle surpassed ACE III’s final close by €4 billion. With leverage of slightly more than 0.5x, the vehicle will have a whopping €10 billion to deploy – amounting to almost $12 billion.
Twin Brook Capital Partners, in market with AG Direct Lending Fund III, has so far collected more than $2 billion, surpassing the goal on its initial close and its predecessor’s size, for lower mid-market direct lending. On the distressed investing side, GSO Capital Partners in April closed on an impressive $7.12 billion for its third distressed debt fund, GSO Capital Solutions Fund III, which surpassed its target by more than $600 million.
The average private debt fund size has grown to a record $1.25 billion as of 31 March, according to PDI data. It has continued to climb since hitting a low of $602.3 million in 2015. Despite the fundraising boom and the asset class’s rapid growth, some first-time credit managers are having a tough time raising capital, sources tell PDI.
4. A good economy means more borrower-friendly documents
Like private credit, private equity has experienced a boom. Private equity managers collected some $455.39 billion last year, the highest amount since the global financial crisis, according to PDI sister publication Private Equity International. Private credit itself collected more than $205.98 billion last year.
The takeaway: there will be more than enough private equity money to chase deals, and there will be plenty of private credit capital to follow that private equity cash. The market remains competitive, with sponsors often dictating the terms of a deal rather than going for what may be prudent for a given business, one source says.
Events that once may have rocked the global economy, such as sabre-rattling between North Korea and the US, have largely left markets unaffected. Even the periods of volatility seen in early 2018 were short lived, indicating there is potential for an even longer bull run.
5. Teaming up for dealflow
Private credit managers will continue to look for different ways to get the upper hand in a crowded marketplace, and this is increasingly done through partnerships, one source said. A high-profile example is the partnership between FS Investments and KKR that became official in April. FS parted ways with GSO Capital Partners, which oversaw sourcing and underwriting deals for its FS Investment Corporation vehicles, and in doing so lost a valuable origination source.
By teaming up with KKR, FS gained access to another deal pipeline through a publicly traded alternative asset manager. Other managers have upped their commitments to existing partnerships or replaced former arrangements that dissolved.
For instance, Ares Capital Corporation and Varagon expanded their joint venture, the Senior Direct Lending Programme, more than doubling it from $2.9 billion to $6.4 billion. In addition, Antares Capital teamed up with Bain Capital to offer a JV focusing on unitranche loans after Lone Star Funds terminated a similar partnership in May 2017.