Challenges in the banking system are expanding the opportunities available to direct lenders. I believe the shifts we’re seeing won’t be short-lived, but, to borrow a phrase from Oaktree Capital Management Co-Chairman Howard Marks, may represent a sea change in private credit.
Direct lenders provide loans to businesses without using an intermediary. This form of private credit has grown dramatically in the last decade, with total assets under management rising nearly seven-fold since the global financial crisis of 2008 to reach roughly $800 billion by mid-2022, according to Preqin.
Private credit has become a popular alternative to syndicated bank loans partly because it can potentially offer more efficiency, certainty of execution, and flexibility. Additionally, private equity firms and other borrowers often prefer to work on a bilateral basis with individual lenders or small groups, as opposed to many lenders with disparate interests.
Direct lending has traditionally been associated with middle-market finance, but in recent years it has expanded to include loans to larger firms. Indeed, private credit funds provided roughly 49% of the debt financing for leveraged buyouts worth more than $1 billion between 2019 and 2022.
I believe direct lenders’ market share will increase significantly in the future due to the substantial mismatch of supply and demand that has emerged in the market for funding large-scale LBOs.
Private credit has become a popular alternative to syndicated bank loans partly because it can potentially offer more efficiency, certainty of execution, and flexibility. Additionally, private equity firms and other borrowers often prefer to work on a bilateral basis with individual lenders or small groups, as opposed to many lenders with disparate interests.
Direct lending has traditionally been associated with middle-market finance, but in recent years it has expanded to include loans to larger firms. Indeed, private credit funds provided roughly 49% of the debt financing for leveraged buyouts worth more than $1 billion between 2019 and 2022.
I believe direct lenders’ market share will increase significantly in the future due to the substantial mismatch of supply and demand that has emerged in the market for funding large-scale LBOs.
This is especially true after the recent failure of Silicon Valley Bank. Its collapse reminded investors of the vulnerabilities that can be revealed when interest rates rise rapidly following a long period of easy money – and how quickly a shortage of liquidity can turn into a capital problem.
While SVB was more vulnerable than other banks, it’s reasonable to assume that all lenders are now paying closer attention to liquidity risks and other potential vulnerabilities. For example, they may face mounting concerns about the health of commercial real estate portfolios, given the rising default rates in certain sectors.
Considering all this, what will it take for banks to consistently resume underwriting massive LBO loans? Beyond having confidence in the health of their own balance sheets and more clarity about the macroeconomic outlook, banks would likely also need to see dependable rising demand from the major buyers of senior loans – collateralized loan obligations and loan retail funds.
In 2022, CLO net issuance was down by over 30% compared to 2021, and loan funds recorded roughly $11 billion in outflows. I believe previous levels of demand in the loan market are unlikely to return quickly, as this would probably require a return to the macroeconomic conditions that existed before 2022.
Not all direct lenders will be able to take advantage of this opportunity, though. Many may lack the scale needed to provide individual loans of $500 million or more. Moreover, a meaningful proportion of direct lenders that deployed capital aggressively in 2020 and 2021 – when leverage ratios were higher and loan terms were much more friendly to borrowers – may now be facing the consequences of lax underwriting standards and bloated debt balances.
Limited competition in the large LBO funding market is pushing up yields and making terms more attractive to creditors. This, in turn, is attracting interest and capital from those direct lenders able to fill the massive gap.
The longer banks remain on the sidelines, the more entrenched these direct lenders can become. And if borrowers and private equity sponsors get accustomed to the flexibility and efficiency that private credit can offer, banks may struggle to regain lost ground. In short, direct lending may be entering a new era.
Source: www.reuters.com