Volatility could be direct lenders’ friend

Fierce competition for deals has led to speculation about the bursting of the direct lending bubble. But troubles in the broadly syndicated market may come to the rescue.

The opening week of 2019 has provided evidence that simply swapping one calendar for another doesn’t necessarily precipitate radical change. When Ares Management announced it had closed its inaugural senior direct lending fund on $3 billion ($5 billion including anticipated leverage), it brought together two of last year’s favourite themes – the growing fundraising power of private debt’s largest managers (as shown by our latest PDI 50 ranking) and the frenzied embrace of the direct lending theme by LPs.

But while this may be familiar territory for the time being, should lenders be bracing themselves for change at some point during 2019? After all, as Refinitiv director of market analysis Fran Beyers pointed out in an interview which formed part of our holiday coverage, the direct lending market has become highly competitive and identifying dealflow more of a challenge. In the face of growing political and financial volatility, direct lenders want to push back on pricing but find it’s a hard thing to do in a market awash with capital and where it’s so important to develop and maintain relationships.

Certainly, from conversations we have had, there appears to be a sharper focus on backing businesses you really believe in. You don’t want to be stuck holding a position in a bad business in an illiquid market. There is also a sense that, with so much macroeconomic uncertainty, a defensive approach is in order – bringing relatively non-cyclical sectors such as TMT and healthcare centre stage.

But while these sensible precautions are being made, there is also a view that it is the broadly syndicated market – where covenant-lite and the erosion of deal terms has been more prevalent than in direct lending – where any problems will strike first and most severely. The syndicated market, driven by a short-term mentality, has seen the most egregious transactional missteps – including the near-normalisation of the much-maligned EBITDA addback.

As a consequence, the volatility that market practitioners often proclaim to fear could be the friend of direct lenders. As syndicated deals begin to suffer the consequences of inflexible documentation, direct lenders may often be the ones stepping forward with longer-term financing solutions – opening a much-needed new channel of dealflow. If this is coupled with a more pronounced retreat from the banks, it’s possible to see the next downturn as more of an opportunity for direct lenders than a threat. Which perhaps – as much as the firm’s brand name heft – explains Ares’ latest windfall.

Write to the author at andy.t@peimedia.com