Direct lending no threat to syndicated debt
Direct lending funds have raised more money than ever this year, and are writing ever bigger cheques in the sort of investments usually done by broad syndication. However, in all but a handful of cases, syndicated financing is the better option.
This year has seen more and more money flow into direct lending funds (AKA private credit, or private debt or credit funds). No matter what you call them, the business is basically the same — instead of being a participant in broadly syndicated leveraged loans or high yield bonds, the investor deals directly with the borrower as a sole lender.
The borrower maintains privacy and discretion, a quick turnaround and certainty of execution, while the deeper relationship with the company can mean the funds in question have the confidence to offer higher leverage multiples. These private funds often offer “unitranche” deals, a financing that would traditionally be split into senior and mezzanine or second lien. Private funds, too, can usually expect stronger documentation than in the public markets, part of the trade-off for their certainty of funding.
More cynical observers of the market point to the opacity of marks in the private debt funds. With no tradeable market, the prices are either “par”, or “impaired” — akin to a banking book, rather than a trading book.
This year, the level of firepower in these funds shot up. Some of the private debt market’s leading firms, such as Alcentra and BlueBay, raised colossal funds — €5.5bn for Alcentra, €6bn for BlueBay, and €6.5bn for Ares last year. Data provider Prequin said the sector had dry powder of $47bn-equivalent by the middle of the year.
Direct lenders also showed up in two high profile cases. Ares financed the whole capital structure of UK tech firm Daisy — admittedly, after the public markets had rebuffed the issuer — while GSO offered a staple financing for Advent’s €3bn buyout of chemicals firm Evonik's methacrylates business. Advent opted for public execution, but the deal ended up as one of the year’s worst, with leads left long even after dropping prices to 95 and below.
Nonetheless, the deal showed that direct lenders had arrived and could offer financing for all but the largest LBOs. Evonik’s capital structure had almost €1.5bn of term debt, while Daisy was a commitment of more than £1bn.
But despite this step change in size, there’s still an awful lot to be gained by using traditional financing sources.
The law of large numbers
Start with the basic set-up. CLOs, the cornerstone buyer base for the senior leveraged loan market, are highly diversified in each vehicle, with perhaps 100 obligors across industries.
Credit committees at the private debt funds are surely full of skilled and brilliant investors with a deep understanding of risk but the law of large numbers works against them. Having 100 different loan positions rather than 10 acts as a hedge against hubris in investment management.
When something goes wrong, too, the CLOs are likely better off, as they’ll trade straight out of their positions to their distressed debt specialist colleagues. Private debt funds have more covenants, and a guaranteed seat at the restructuring table, but are unlikely to be able to get out of their position — and will be unlikely to allow any investor but themselves to contribute new money and prime their debt, limiting the range of turnaround options for a company in trouble.
Direct lending vehicles also lose out in terms of leverage firepower. CLOs are typically 10x levered, while a direct lending fund might be 2x or 3x at best. Because prices aren’t observable and assets aren’t tradeable, fund-level leverage for direct credit funds is clunkier and less competitive than CLOs, which can be structured with any number of carefully calibrated constraints to bring the cost of financing down and extend the financing terms.
Put simply, the clearer the value and quality of a portfolio it is, the more generous lenders, be they banks or CLO bondholders, can afford to be.
Direct lending funds also struggle to solve the basic problem of origination. Given that the biggest banks have vast incumbency advantages, and relationship managers for companies of all sizes, how can a more fragmented fund industry compete?
Boutiques, typically staffed by former levfin bankers, help connect lenders and borrowers, as do the large accountancy firms, many of which have private debt operations. For all the talk of disintermediating the big banks, there is a real advantage to being the established market middleman, and, in the end, the banks just have more warm bodies to throw into finding deals. Fund managers would surely rather hire in portfolio management and credit than try to replicate the relationships that investment banks and commercial banks already hold.
As the direct lending powder has piled up, the thin supply of large deals has given the funds a problem — they need to spend the money or give it back. Increasingly, that has meant spending the money buying second lien pieces of LBOs, where the senior debt has been broadly syndicated. That shoves the cash out of the door at least, but it concentrates risks further in the sector.
Direct lending has its place — as a last resort for complex or difficult deals, as a true competitor for small, highly levered deals, or as a way to raise finance with maximum stealth. But despite the step-up in size of the sector, it’s not a true threat to the bread and butter of the syndicated market.