At a time of seemingly relentless macroeconomic and geopolitical uncertainty and dislocation, the direct lending offering appears more relevant than ever in the global mid-market. Buoyed by compelling underlying growth drivers including the exponential onward expansion of private equity and a banking retrenchment, direct lenders don’t appear too rattled by a more challenging backdrop.
Direct lending strategies remain top of the shopping list for investors in private debt, with 47 percent of LPs planning to invest more in those during 2023 than they did last year, according to Private Debt Investor’s LP Perspectives 2023 Study.
Eric Capp, partner at Pemberton Asset Management, says: “Private equity in Europe has been growing rapidly over the years and based on industry data is close to €1.5 trillion. As a result, there is considerable capital in the market to consolidate European mid-cap corporates.
“That consolidation trend from family ownership to institutional ownership requires debt capital alongside private equity, and while the banks supported private equity for some time, since the global financial crisis a combination of regulatory pressures, decreased risk appetite and shareholder demands has seen them retreat.
“With banks pulling back from mid-cap corporate lending, and especially sponsor-backed deals, debt funds have been able to fill that gap.
“We believe that long-term mega-trend creates a fundamental growth opportunity for private debt, and while that can go up and down a bit with the M&A market, it is not going to go away and will continue for the foreseeable future.”
Andrew Bellis, global head of private debt at Partners Group, agrees that the growth direct lending has seen over the past decade is unlikely to decline and may, in fact, benefit from this period of economic slowdown.
“All the original rationale for why private debt should grow remains true: banks don’t want to lend to mid-market corporates, institutional LPs are interested in the strategy as an alternative to fixed-income and sponsors are raising more capital and need more debt to support their companies,” says Bellis.
“Every time we go through one of these episodes of market volatility, the private credit market takes share from other markets, and particularly the syndicated market because that tends to shut down.
“At some point that flows back because the syndicated market becomes more aggressive again, but each time the direct lending market has more capital to deploy and so becomes an increasingly strong source of competition.
“I don’t see that trend changing, with direct lending now growing everywhere from a global perspective. If you look at the size this market could get to in the UK, there is still substantial potential, while in Europe it is coming from a lower base and so will perhaps grow even faster.”
Zach Lewy, founder and group chief executive of Arrow Global, says the direct lending product is evolving and catering to the needs of a growing number of borrowers. “What we see in this market is that vanilla lending that is less operationally intensive remains central to the banking system, but all the things that fall outside this have found their way into direct lending formats.
“[This could be] down to the operational intensity of the loan, as in things like construction lending that requires lenders to be visiting sites and being hands-on, or it is down to a need for greater structuring in areas like bridge lending and certain types of sponsored credit where there are real-world risks that need to be managed.
“Those products respond to what borrowers need right now and are at the epicentre of the direct lending world, and not in the banking world, and that is an increasing shift.”
Throw in the fact that the bulk of direct lending is done on floating rates, offering inflation protection as base rates rise, and the asset class looks as compelling to investors as it does to the sponsors and mid-market business owners tapping its capital.
More attractive than ever
Anthony Fobel, CEO of Arcmont Asset Management, argues that direct lending has never been more attractive as an asset class, pointing to five reasons. First, he says, deal volumes are attractive because the banks and the public markets have been largely absent from corporate lending for the past year.
“Second, pricing has improved both in terms of base rates and spreads,” he says. “Third, leverage multiples have come down as people are more conservative with capital structures. Fourth, terms have improved as a function of supply and demand to become significantly more lender-friendly. And the fifth point is that the growth in private debt firms means they can now finance larger, better-quality businesses than they could a decade ago.”
Given such dynamics, standing out in a crowded market full of mid-market direct lenders is not for the faint of heart. Nicolas Nedelec, a managing director working in private debt at Eurazeo, says: “At the end of the day, the way you differentiate yourself in direct lending is not only on pricing and leverage any more but on reputation and track record. You can’t have 200 firms differentiating on those criteria, so it is likely the universe of funds will diminish as the market matures. There are already signs of maturity in the number of players.
“A few years ago, differentiation was mostly about pricing and leverage because nobody had had time to build up track records. Now, the firms are identified, the individuals are identified and working partners with history and a good reputation have become really important.
“It is not necessarily the case that relationships beat one turn of leverage or 100 basis points of pricing, but if a sponsor wants to do M&A and they want to enter into new markets with a partner that understands them, is able to offer flexible capital and won’t get in the way, that has real value. It probably beats 50 basis points.”
In a tricky economic climate, borrowers are looking for a little something extra from a credit provider, and direct lenders look most capable of stepping up.