Pictured Benjamin Owens and David Zhou

Private credit has existed for decades, but it has received increasing attention in recent years.  What used to be viewed as a niche product to fill gaps where traditional bank lending was not readily available has become a mainstream financing option that is directly competing with, and displacing, commercial bank loans.  Many articles compare syndicated loans and private credit loans as asset classes, often noting the faster execution of private credit lenders and the lower cost of capital in syndicated bank deals. However, these types of articles often skip over the practical challenges that can arise when refinancing a syndicated bank loan with a private credit loan.  This article will highlight several of those topics and the related considerations that borrowers in the middle market and lower middle market should keep in mind.

Why Consider Private Credit?

Private credit and, more particularly, direct lending as a sub-set thereof, is a competitive financing option for borrowers in the middle market and lower middle market.  The key benefits of direct lending are often emphasized in the context of acquisition financings—where bank lenders may need to take time to form the lending syndicate and the terms of the financing may be subject to “market flex” provisions—but borrowers increasingly seek to refinance existing syndicated bank loans with private credit loans even outside of an active M&A transaction.  

Borrowers may choose this path for several reasons.  For example, companies pursuing inorganic growth strategies may benefit from private credit deals, which typically feature lower debt service than syndicated bank loans.  This is often achieved through little or no principal amortization and the use of payment in kind (PIK) interest. Direct lenders are also more likely to offer higher financial maintenance covenant levels than banks, which are constrained by regulatory limits. As a result, these borrowers can increase their leverage and use more of their balance-sheet cash for acquisitions, expanding their ability to grow and boost earnings before interest, taxes, depreciation and amortization (EBITDA). 

Another scenario involves borrowers with inconsistent performance.  Such a borrower may have trouble accessing the desired amount of debt from commercial banks, who will often evaluate a potential deal through either a cash flow (evaluating the borrower’s financial performance, typically based on EBITDA, over the past few fiscal periods) or asset-based (evaluating the amount of pledged assets, typically consisting of some combination of accounts receivables, inventory and equipment, available to secure the loan) lens.  This borrower may turn to direct lenders who may be able to be more flexible, sometimes relying on the sponsor’s track record or willing to consider atypical collateral or credit structures.

These observations generally apply to the middle and lower middle markets. However, certain niche markets operate differently.  For example, direct lenders have been very active for decades in lending to early-stage life science and technology companies, which have had trouble accessing the commercial bank market due to the lack of a financial track record (making it difficult for banks to evaluate these deals on a cash-flow basis) and assets consisting primarily (at least in terms of value) of intellectual property (which is harder for banks to value and lend against on an asset-based basis).

Consideration 1: General Approach to Loan Documentation

A key initial consideration for borrowers is the approach to documentation. In this hypothetical scenario, the borrower has an existing syndicated bank loan, with a credit agreement almost certainly based on the LSTA form. Many direct lenders also use LSTA-based documentation, so there are likely to be many similarities between the borrower’s current credit agreement and the direct lender’s standard form. 

Using the borrower’s existing credit agreement as a starting point for new financing can often create both cost and time efficiencies during negotiations. The representations and warranties, covenants and events of default in the existing agreement should, in theory, already align with the borrower’s operations. This allows negotiations to focus mainly on a few “hot button” issues raised by the new lender or on areas where the borrower’s needs have changed since the original deal.  In addition, direct lenders often have fewer internal operational requirements than banks and can therefore often accept most of the operational provisions in the prior bank credit agreement.

Alternatively, sponsors and direct lenders may prefer to use precedent from other deals they have negotiated together as their starting point. This approach can help minimize negotiation over key issues for both the lender and the sponsor, but it still requires tailoring provisions to the specific borrower and its operational needs.

It is difficult to say definitively which documentation approach will be most efficient, either in general or for a particular deal. The answer often depends on the preferences and policies of the lender, sponsor and borrower, as well as the extent to which the borrower’s needs require changes to the standard representations, covenants and events of default. In some cases, the structure of the new private credit deal may differ so much from the existing syndicated loan that starting with the current agreement offers little benefit. The lender may also insist on using its own preferred forms. Regardless, borrowers should actively consider and discuss documentation approaches with potential lenders when refinancing an existing credit facility, as the right approach can lead to significant savings in both time and legal fees.

Consideration 2: Preserving Working Capital

A second important consideration for borrowers is their working capital needs. Syndicated bank loans often include both term loan and revolving credit components. Many companies rely on revolving credit facilities as a key tool for managing liquidity, using them to supplement internally generated cash. Revolvers may also include letter of credit subfacilities, allowing one or more banks to issue letters of credit on the borrower’s behalf.  Access to these letters of credit may be essential for a borrower’s business, for example, by supporting real estate leases, facilitating import/export transactions or satisfying regulatory requirements.

Historically, many direct lenders in the middle and lower middle markets have not offered revolving credit facilities. Managing frequent borrowings and repayments on a revolver is administratively complex, and private credit firms often lack the robust operations teams found at commercial banks. However, this is changing. In recent years, more direct lenders have begun to offer revolvers to differentiate themselves from other direct lenders and to more aggressively compete with banks.

Any borrower that is contemplating the move from a commercial bank facility to a private credit facility will need to think about its working capital and letter of credit needs and ensure that such needs are either (1) provided under the new private credit deal, which could limit the universe of direct lenders to only those that are able to provide revolving credit facilities, or (2) permitted to be obtained by the borrower outside of the private credit financing.  Private credit deals without a revolving credit component often allow the borrower to obtain a revolver from another lender, subject to certain conditions. Negotiations typically focus on the permitted size of the revolver, whether it must be subject to a borrowing base (and, if so, the advance rates), and the collateral available to secure the revolver.  If the intent is for the revolver to close simultaneously with the private credit deal, then the parties will need to enter into an intercreditor agreement at that time.  In some cases where the revolver will be entered into after the term loan (private credit) financing closes (and is therefore permitted on a prospective basis), the borrower and the private credit lender may want to go ahead and agree on a form of intercreditor agreement to use in the future. 

Borrowers who only need letters of credit outside the new private credit deal face less complexity. In these cases, the borrower simply negotiates permissions for the anticipated letters of credit into the new credit agreement, particularly within the negative covenants on debt and, if the letters of credit will be cash collateralized, liens. This is usually a straightforward discussion unless the borrower requires an unusually large capacity for letters of credit.

Borrowers needing a revolver or letters of credit should raise these topics early with potential private credit lenders. Early discussions help avoid costly delays and ensure that all parties are aligned on the structure from the outset.  Alternatively, when the need for a separate revolver is not identified or discussed until after high level terms have been agreed by the parties and the loan documentation is in process, it can lead to very difficult discussions on the business side.

Consideration 3: Debt Service Obligations.

Another consideration for borrowers when contemplating a refinancing is the difference in fees and debt service between direct lender deals and syndicated bank deals.

Both types of financing require payment of upfront, arrangement, and similar fees at closing. However, the total amount of these fees is typically higher for direct lender deals than for syndicated loans. After closing, syndicated bank deals usually involve minimal ongoing fees, such as an annual administrative agency fee and unused fees for undrawn amounts on revolvers or delayed draw term loans. These deals almost never include a prepayment premium (sometimes called a prepayment penalty) or an exit fee. In contrast, direct lender deals often include significant prepayment premiums—which may decrease over time and can even take the form of a “make-whole” in the first year or two—and substantial exit fees payable at maturity or upon early refinancing. These additional fees may not be a concern for borrowers as they are often triggered by a liquidity event, such as a sale of the borrower by the sponsor or a debt refinancing, when there is ample capital to repay the facility and related fees.

While bank deals generally have lower fees than direct lending deals, they often come with higher debt service requirements over the life of the loan. Commercial banks typically require significant principal amortization on term loans, sometimes amounting to 30–50 percent of the total term debt. They also almost always require regular payments of cash interest. 

Direct lenders, on the other hand, can offer structures with much lower debt service. They often provide term debt with little or no principal amortization until maturity—annual amortization of around 1 percent is common. Additionally, direct lenders may offer a PIK interest component, either for the entire term or for the first few years, which reduces the amount of cash interest the borrower must pay. Lower debt service frees up cash for the borrower, allowing it to be used elsewhere, such as for acquisitions or other expansion activities.

Borrowers considering a private credit deal should be aware of these differences and ensure the structure aligns with their business plan. For example, if a sale is expected in the near term, it may not make sense to take on more expensive capital with a prepayment premium and exit fee. However, if the borrower does not anticipate an imminent refinancing or liquidity event and wants to benefit from lower debt service, a private credit deal can be a strong option.

As the private credit market continues to grow, the relationship between private credit deals and syndicated bank deals will continue to evolve. This shift will create new opportunities for borrowers, along with new considerations when comparing these financing options. Borrowers who understand both markets and the relative advantages and disadvantages of each will be better positioned to secure the optimal financing solution for their needs.