In the direct lending landscape, it looks like funds, rather than banks, are riding high. Deloitte’s alternative lending tracker recorded 95 such trades in EMEA in the third quarter of 2017 — the highest level on record.
Lending to small and medium sized businesses used to be firmly the province of banks, often local relationship institutions, but things have changed. Raising cash from funds used to be a niche option for borrowers with peculiar ambitions or difficult capital structures — after all, bank loans ought always to be cheaper. Banks subsidise lending through ancillary business, and have a much lower cost of capital than funds.
The conditions which have pushed institutional capital into direct lending are set to change though, as central banks start to tighten extraordinary liquidity and raise interest rates.
But this is unlikely to turn back the clock. An end to ECB purchasing will hit liquid markets like government bonds first, and hardest. High yield buyers could also return en masse to investment grade corporates, once no longer priced out by central banks.
If private debt funds see withdrawals, the illiquidity of the asset class could be a problem — selling books of loans is far harder than selling securities. In general, funds have lent money expecting to be invested for the long term.
More importantly, the funds entering the market have invested heavily in infrastructure and hiring people that can access the direct lending market, and they are unlikely to pull out just because interest rates go up.
Direct lending has lots going for it. Funds can deploy formats like unitranche loans, which combine first and second lien tranches, which borrowers appreciate as they come with less restrictive terms. Borrowers pay a fee, which at this point in the cycle is typically about 2%-3%, spread overthe life of the investment.
Stretched senior direct lending deals, larger senior loans that direct lenders offer, yield a large return, typically around 4%-6%, while super-senior tranches deliver more like 1.5% to 1.75%, according to Barings.
Though funds generally have a higher cost of capital than banks, as they are much less leveraged, they have regulatory advantages. A fund does not have to be concerned with risk-weighted assets, so can more easily stretch to lending unitranche, which includes mezzanine risk.
But funds can also win out through execution prowess, moving quickly to spot opportunities.
“When you are a bank you have the infrastructure, you have back offices. It is easier for someone who establishes a fund, you don’t need a complete lending engine, which a bank has got in situ,” says Paul Burdell, a co-founder of LCM Partners, which runs a direct lending fund, data company and loan servicer.
To understand the growth of private debt, Burdell says, it is worth looking back at the financial crisis.
“A lot of banks retrenched themselves and went back home,” he says. “Where multinationals operated around Europe, now the business happens at headquarters.”
Clients looking for loans have complained that in order to support a multinational operation across several European countries they have had to establish relationships with different bank branches.
“That causes our clients a lot of angst. We don’t have this problem. As a fund we are borderless,” says Burdell, whose fund has 10 offices in eight European countries.
David Hirschmann, head of direct lending at Permira Debt Managers in London, says funds tend to have a more flexible business model than big banks. “We have a team of 40 people who all sit together,” he says. “Companies have direct access to the people who sit on the investment committee and make lending decisions on a pan-European basis.”
These funds have lots of money to be deployed into direct lending strategies. Deloitte cites $30.7bn of cash raised for direct lending in 2017, up from $25.8bn the year before.
Bigger and riskier
That has spurred larger deals in the private markets, which have encroached on the traditional territory of syndicated bank loans.
Nigel Houghton, managing director at the Loan Market Association, says competition for smaller mid-cap business is hot. “However, instead of going further down the scale into corporate SME territory,” he says, “these funds are scaling up to target what would ordinarily have been a bank club deal or smaller syndication.”
And as the direct lending market matures, funds are looking beyond standard loans — and even beyond unitranche or stretched senior.
Funds are using payment-in-kind (PIK) debt, where the interest is rolled up as extra debt instead of being paid in cash on a running basis. PIK loans can be made available to the holding company of a unitranche borrower so that it can increase its overall leverage. Alternatively, funds can offer preferred equity or a synthetic equivalent, where the transaction would not allow for increased leverage.
“These instruments improve returns in a relatively low margin environment, but also add more rewards to deals that carry more risk,” says Philip Stopford, finance partner at law firm Shearman & Sterling.
Many of these companies looking for more aggressive leverage than they could easily get from banks are private equity-owned midcaps.
“At PDM, about 80% of our direct lending activity is to small and mid-sized companies that are owned by private equity firms,” says Hirschmann.
Dog eat dog
The competition between all these debt providers is not always friendly.
Sometimes a firm, or its adviser, might try to convince funds offering direct lending to compete. This would involve asking for a shortened version of terms and conditions and pricing called a ‘short form grid’ from each prospective lender, and then playing one against the other.
That is no different from a borrower shopping around between banks, but still, the advent of direct competition is hurting direct lenders’ returns and weakening creditor protection.
Larger funds have also started to swipe deals from under banks’ noses.
In 2016 chemical company Polynt began a merger with Reichhold, which was slated to be financed with a bond. But GSO Capital Finance cut in on the banks’ business with a €625m unitranche loan, the largest such deal it had financed at that point.
“It was huge,” says Stopford.
Sometimes, though, banks are simply taking deals from each other. Last summer, Goldman Sachs swooped to provide Bridgepoint a unitranche loan instead of the syndicated loan it had been negotiating with HSBC, Royal Bank of Scotland and Lloyds Bank.
Some deals have involved more aggressive competition, but some have just got bigger. In North America, where direct lending has been around for longer and is more developed, unitranche loans were used for two of the biggest direct lending deals in 2017.
Apollo’s purchase of West Corp, a telecoms company, used a unitranche loan within its $4.1bn financing and Golub Capital helped Saba Software’s acquisition of Halogen Software with a $375m unitranche loan.
“Direct lenders are becoming more aggressive on both pricing and risk taking — sometimes deploying capital on deals that got rejected by banks,” said Bank of America Merrill Lynch in a research note in February.
It’s not all competition, though. Direct lenders are increasingly clubbing together to do deals, much as a bank might syndicate a large issue.
So far, the young direct lending market has not suffered many defaults — hardly surprising, when it has not been through a credit downcycle yet. What worries some market participants is what will happen to the more aggressive deals when the economy hits trouble.
Paul Mullen, a unitranche partner at law firm Hogan Lovells, says that in two defaults he has come across, the corporate restructuring has been worked out, sometimes with the lender ending up with equity. But it might be harder if a wave of restructurings happen at once.
“Do these funds have the internal resources to deal with a number of restructurings going on at the same time?” asks Mullen. “Some of the debt funds that have been out there for a long time have seen this as a possibility and have taken on board their own restructuring specialist, but not all of them, by any means.”
There is no easy exit door by selling out. Unitranche deals are effectively bilateral loans but drafted and documented as if they were syndicated loans. Although it is legally possible to transfer them, there is no real secondary market.
Small is beautiful
While aggression has played out in the top of the market, the rest of the industry has continued to function and mature. Single deals now average up to €300m, says Mullen. “There are outliers, again. People like GSO, KKR who will do more than that. But the players that you are seeing more regularly in the market are looking at up to the €300m level,” he says.
As more capital, experience and guts have allowed direct lenders to go after larger deals, a gap has opened up in the market again where unitranche and direct lending began — with the smallest companies.
Lending to SMEs often requires a local presence, which incumbent and challenger banks and some smaller funds are better set up for. But some funds simply don’t want to make that level of infrastructure commitment, and prefer to go after midcaps.
Hadrian’s Wall Secured Investments (HWSIL) lends to SMEs in the UK on a whole loan basis. Selected deals on its website range between £1.5m and £14m. Borrowers provide security against the loan in the form of tangible or intangible assets.
Ron Miao, chief operating officer of HWSIL, says some clients chose his company because a bank loan may have too many restrictions or requirements.
“The SME sector is our niche,” says Miao. “We are willing to take the time and energy to establish relationships with small businesses and become a partner with them. We are a term lender. Our borrowers have the certainty of term financing and can therefore grow their business with the confidence of having term capital in place and ultimately get to the point where they are a bankable client.”
After that, Miao says the client can go to a bank and get a much more cost-effective loan. But in the interim, his company gives them access to financing to help them achieve their goals.
If the market is too hot at the top, perhaps it is time for direct lenders to look small again.