Direct Lending: A Closer Look

• The US direct lending market has grown in popularity in recent years, thanks to a shifting regulatory landscape which has prompted borrowers to seek alternatives to traditional bank financing.
• Direct lending offers a number of advantages over banks for both borrowers and investors in the asset class, but there are also risks to consider.
• We also take a look at some of the key players in the US direct lending industry, and underscore some important trends to consider.

What is Direct Lending?

Direct lending is a type of financing provided by non-bank capital providers which typically targets middle-market corporations. These companies might use the funds for a range of purposes, including buyouts, working capital, M&A and recapitalizations.

US direct lending is unregulated, meaning direct lenders can pursue higher risk deals that banks eschew due to regulatory constraints (we’ll cover the regulatory impact on the US direct lending sector in greater detail below). As a result, US direct lenders tend to finance middle-market borrowers more often than banks. Banks also look to syndicate loans (slice them up and sell off shares to outside investors), and since most middle-market loans are not large enough to syndicate, banks typically focus on large-cap borrowers. That provides an opening for direct lenders, as the middle-market sector remains  underserved by traditional banks. 

For these reasons, there has been a spike in interest in US direct lending over the last decade amongst borrowers. But these direct lenders are often borrowers themselves, courting investment from a range of institutional capital providers. LPs have also grown more attracted to direct lending, their interest fueled by a growing appetite for the idiosyncratic features of the asset class, including floating rate income streams, a senior secured creditor position, and the creditor’s ability to design bespoke structures that reduce risk.  

Below, we’ll discuss the various features of direct lending in greater detail, including the benefits, risks, and key players in the market.

Benefits of Direct Lending

Direct lending has numerous benefits to both the borrower, and the investors in the asset class (the direct lender’s limited partners).

First, we’ll start with the benefits to the borrower:

• Access to Capital: Direct lending can provide companies with access to capital that they may otherwise not be able to obtain. The reasons for this vary, but typically involve a risk profile that traditional banks are unwilling to loan against. Borrowers with higher risk profiles benefit from a direct lender’s willingness to accept additional risk. 
• Efficiency: Direct lenders can typically provide financing more quickly than banks, which have to receive approval on deals amongst various departments before signing off on the loan. Direct lenders are relatively small, entrepreneurial and nimble organizations, with very few layers, thus accelerating their deal sourcing and diligence processes.
• Increased Flexibility: Direct lenders are often willing to tailor financing packages to meet the specific needs of borrowers. Some middle-market companies have unique structural needs, and thus aren’t the right fit for banks or other large institutions. Direct lenders fill this gap in the market, as they are capable of delivering bespoke debt structures.

 Now, let’s take a look at the benefits to investors in the direct lending asset class:

• Interest Rate Protection: One of the primary concerns when issuing a loan is rising interest rates. If a loan is made at a fixed rate and then interest rates rise, the value of the loan decreases. For example, if a bank loan yields 5% when interest rates are 2%, then the bank earns the 3% difference. If interest rates rise to 4%, suddenly the bank is earning 1% on the same loan. And if interest rates rise further to 6%, the bank is losing 1% on the loan. Direct lenders protect against this risk by issuing floating-rate loans, meaning the interest rates of direct loans rise as the broader interest rate increases. Additionally, direct loans have shorter duration periods (typically 5-7 years), which means they have less sensitivity to interest rate changes overall.
• Seniority and Covenants: Another chief concern for lenders is how they will recoup their money should a borrower default. Direct loans are senior-secured, meaning they are first in line to be paid out in the event of a default. Additionally, direct loans are covenant-heavy, and include restrictions to borrower activities like adding additional debt, as well as maintenance restrictions such as requiring borrowers to maintain a certain debt-to-equity or interest coverage metrics. This is in contrast to traditional bank loans, which don’t typically include maintenance requirements.
• Greater Upside Potential: The spread on first-lien middle-market loans is often larger than the spread on first-lien large-corporation loans (‘spread’ being the difference between the coupon rate of the loan and a benchmark interest rate). So direct loans have greater upside potential than traditional bank loans. They can also feature additional sweeteners such as warrants (the right to purchase stock at a set price, within a set amount of time). This provides direct lenders equity-like upside, should they choose to exercise their warrants. Direct lenders can also limit their downside risk, given the bespoke arrangements of these loans. For example, direct loans might include call protection, which restricts borrowers from ‘calling back’ the loan before the maturity date, thus eliminating prepayment risk.
• Diversification: Direct loans are not highly correlated with broader markets, especially when issued to companies in esoteric industries that remain siloed from broader economic cycles and geopolitical events. So limited partners in direct lenders enjoy diversification during times of macroeconomic distress.

Risks of Direct Lending

Direct lending isn’t a panacea. Along with the many benefits, come a variety of risks to both borrowers and LPs.

Let’s start with borrower risk:

• Less Regulatory Oversight: Direct lenders are not subject to the same regulatory oversight as banks, which implies that they are at a higher risk of distress or default (one could argue that regulatory oversight does little to reduce such risks, but that is an ongoing debate, and beyond the scope of this piece). One thing is certain: direct lenders are not as well-capitalized as banks, hence they are more exposed to borrower risk (meaning if borrowers default, this is more likely to trigger liquidity issues for direct lenders than it is for banks). Borrowers need to be aware of this risk, as a direct lender’s liquidity issues might impact a borrower’s ability to obtain capital from the same lender.
• Strict Covenants: Direct lending contracts usually contain stringent covenants that limit the borrower’s capacity to decrease the loan’s value. These safeguards mandate that borrowers fulfill certain financial requirements, such as maintaining a debt-to-EBITDA ratio, or other maintenance requirements that limit the lender’s downside risk.

Those are the risks to the borrower. Now, let’s take a look at the risks to a direct lender’s investors, or LPs:

• Heavy Reliance on Manual Processes: Direct lenders provide bespoke financing, which means they must source, structure, underwrite and monitor investments with a finer attention to detail, and in certain cases, sector-specific expertise. That implies a heavy time commitment on the part of the lender, which must allocate its resources effectively across the universe of prospective deals. But there’s good news here – this risk is being mitigated by the advent of digital platforms such as CAPX, which reduce the manual processes involved in sourcing and structuring loans. These platforms make the loan sourcing and diligence process more accessible, so lenders can originate, execute and monitor deals more efficiently, and with fewer resources committed.
• Increasing Competition: As an industry evolves, new entrants emerge. In a recent Proskauer Rose survey, competition was ranked the #1 concern amongst Private Credit issuers in 2022. This implies that lending standards won’t be as strict as they otherwise might be, given the growth of direct lending within the middle-market lending sector (more on this below). In other words, competition is forcing direct lenders to loosen their lending standards (examples include lending at higher multiples of EBITDA, and agreeing to more earnings add-backs, which can inflate a company’s EBITDA and make leverage levels appear artificially low).
• Leverage Refinancing Risk: Direct lenders have their own capital sources, and typically use leverage offered by commercial banks to amplify their return profile. Yet this fund-level leverage is often shorter duration than the loans issued to borrowers, creating a leverage refinancing risk. Commercial banks may also stipulate their own covenants, including accelerated repayment of the loan should the value of a direct lender’s portfolio decline, thus creating added liquidity problems for direct lenders in times of broader economic distress.

Key Players in the Market

US direct lenders are often arms of asset managers, including middle market investment banks, private equity firms, business development companies and hedge funds. 

Some of the key players in US direct lending include:

• Apollo Global Management: One of the largest direct lenders in the world, with over $400 billion in assets under management.
• Ares Management: Another large direct lender, with over $300 billion in AUM.
• Blackstone: One of the largest private equity firms in the world, with nearly $1 trillion in AUM. Blackstone has a large direct lending business, with over $60 [JF2] billion in assets.
• KKR: Another major private equity firm, with nearly $500 billion in AUM. KKR also has a large and growing direct lending business that sits within its nearly $200 billion credit division.
• Oaktree Capital Management: A leading direct lender, with over $150 billion in assets under management.
• TPG: Another large private equity firm with over $100 billion in assets under management. TPG has a direct lending business, with over $20 billion in assets.

Direct lenders must raise capital from outside investors—their LPs. Much like traditional PE funds, they earn income through management fees and carry (incentive fees).

Direct lenders source pools of capital from larger institutions, including:

• Asset managers: Many direct lenders are affiliated with broader asset management firms that implement a range of investment strategies. This encompasses everything from large investment banks like Goldman Sachs and Morgan Stanley, to private equity and hedge funds / multi strategy funds. Asset managers looking to exploit new avenues for growth and diversify their revenue streams are attracted to the relatively esoteric nature of direct lending. 
• Insurance companies: Insurance companies are another major source of capital for direct lenders, as they seek investment opportunities uncorrelated with the broader market.
• Pension funds, Endowments and Sovereign Wealth Funds: These large institutional players often provide long-term financing for direct lenders.  

Growth of US Direct Lending

Over the decade following the Great Recession, US direct lending assets under management jumped by nearly 1,000%. By 2020, total US direct lending had grown to around $800 billion, according to a Refinitiv estimate. The consolidation of banks has played a major role here, as regional middle-market investment banks were gobbled up by larger national entities, which focused on more lucrative financings of larger firms. That left an opening for direct lenders to exploit. In the last year alone (Q2 2021 – Q2 2022) the value of the US direct lending market increased 30%, from $52Bn to $68Bn.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in response to the global financial crisis of 2008, also helped spark the direct lending boom of the last decade by introducing new rules and regulations for banks. As a result of Dodd-Frank, banks have reduced their allocation of loans to middle-market firms, especially those with riskier credit profiles. Direct lenders have been able to fill this void by providing financing to middle-market companies that might not otherwise be able to access capital.

The JOBS Act, which was signed into law by President Obama in 2012, also had an impact on US direct lending. The JOBS Act lifted some of the restrictions on advertising and solicitation for private placement deals. It also reduced regulation and oversight of companies earning less than $1 billion in annual revenue. As a result of the JOBS Act, US direct lenders have been able to reach a wider audience of potential investors, and middle-market companies face less stringent rules as they look to scale their business.

Trends to Consider

• Middle-Market Refinancing: According to Oaktree Capital, over $550 billion in middle-market debt is scheduled to mature through 2027. As economic constraints continue to weigh heavily on banks, BDCs and other large institutions, forced asset sales may be on the horizon, which implies attractive M&A opportunities for patient investors. Direct lenders may well benefit from this paradigm, as increased M&A activity should give rise to lending opportunities.   
• Dry Powder + Increased Competition = Active Marketplace: Private equity firms are sitting on mountains of dry powder (capital sitting on the sidelines, waiting to be put to work). Prequin estimates the global dry powder figure to be $1.8Tn. Many firms built up record reserves during 2020, unsure of how the COVID pandemic would unfold. The worst-case scenario failed to materialize, yet uncertainty continues to plague the macro-economy, thanks to various headwinds including inflation, the Fed pullback, supply chain woes, and the Russia-Ukraine conflict. That excess dry powder can’t stay dry forever—PE firms exist to put capital to work, hence many are speculating a sustained uptick in direct lending activity. And with competition rising in the direct lending sector, lenders cannot afford to be too stringent with their lending requirements. Those are the ingredients for a very active marketplace going forward.
• Uncertainty is the Name of the Game: One thing remains clear—that nothing is clear. Are we headed into a recession? If so, will it be mild or massive or something in between? How sustained will inflation be? How will the Russia-Ukraine conflict play out? Will China invade Taiwan? When will supply chain troubles resolve? Some of these are impossible to predict, and others only with a minimal degree of certainty. Hence, many firms are approaching the current moment with something akin to cautious optimism. No one wants to overcommit, yet no one wants to be left out in the cold, either. Should troubles resolve and the economy land on sturdier footing by 2023, direct lenders issuing capital now stand to reap massive benefits.

Direct Lending Solutions

Direct lending is an asset class that has historically generated attractive, risk-adjusted returns through a variety of business cycles. Indeed, over the long-term, direct lending has consistently outperformed other income-oriented strategies on a risk-adjusted basis.

Regulatory changes and bank consolidation have exposed a gap in the market for direct lenders to exploit. As a result, the industry has grown steadily over the last decade, with larger deals materializing, and prominent institutional brands entering the space.

No one knows what the future holds. That said, direct lenders who exhibit patience, leverage relationships, and structure bespoke deals that meet the shifting needs of middle-market borrowers will position themselves to capture alpha should the economy recover in the short to medium-term.