Direct Lenders Ready for Bonanza as US Economy Cools

Private credit funds with deep pockets, capital flexibility and sticky investments are positioning themselves for the yield bonanza that could follow if a cooldown in the US economy was to further shutter bank liquidity and investor appetite for broadly syndicated loans.

Banks, wary of an economic downturn, have in some instances stepped back from lending to companies perceived as riskier. Private debt investors, including private equity firms and business development companies (BDCs), are filling the void, siphoning liquidity to leveraged borrowers in the absence of traditional sources of debt.

Private debt funds globally raised US$110bn in 2018 and US$129bn in 2017, according to research firm Preqin. This year, even when the leveraged loan business has shrunk, investors are expected to allocate more than US$100bn to private credit funds.

“A lot of capital formation has been done, especially since 2008, in the private credit space. In many ways, those pools of capital, and we can pick our BDC, are looking forward to that volatility,” said Dan Pietrzak, co-head of private credit at KKR & Co.

Direct lenders are well-positioned to weather an economic downturn as they are closed-end funds, which lock up capital unlike open-end funds, and do not face the same regulatory hurdles that banks, which still arrange the lion’s share of leveraged loans, are behooved to.

Pools of private credit also benefit from the opacity of the asset class. Loan documents are negotiated as a bilateral agreement or between a club of lenders, as opposed to a broad syndicate that then farms the debt among several institutional buyers. And throughout economic hardship, a debt restructuring can be simpler to negotiate among a tight-knit group.

“It can be easier to get everyone in a room and modify the arrangements of a loan, whereas capital structures containing public securities might be less forgiving,” said Jonathan Insull, managing director at Crescent Capital Group.

Direct lenders have become more prominent as Collateralized Loan Obligations (CLOs), wary of the end of the cycle, have demanded better compensation for their risk when investing in Single B rated, broadly syndicated deals that could fall into the riskier Triple C territory ahead of a downturn. CLOs, which are the biggest buyers of institutional term loans, have limits on the number of loans they can hold with Triple C ratings.

Adding to the appeal of direct lenders, with CLO managers demanding higher interest payments and greater protections, the syndicated market is no longer cheaper for borrowers. Throughout the fourth quarter of 2019, Single B rated syndicated loans in the middle market have increased to an average yield of roughly 8%, compared to about 7.4% a year prior, according to data from Refinitiv LPC. And during September and October, at least 17 Single B rated borrowers saw their syndicated loans price wider than the initial terms on offer.

UNTESTED

Year-to-date, at least 12 unitranche loans in excess of US$500m have been arranged by direct lenders, up from seven in 2018. In October, insurance broker Risk Strategies obtained a US$1.6bn unitranche from 10 direct lenders, making it one of the largest loans of its type arranged to date.

While direct lenders have picked up a bigger piece of the pie, the burgeoning funds are yet to experience the headwinds of an economic downturn.

“These direct lenders have not been battle-tested, so it’s hard to say how equipped they are to tackle cyclical volatility,” said a portfolio manager that focuses on the middle market.

Direct lenders have to be comfortable with the buy-and-hold nature of private loans. Unlike investors in an institutional term loan B, private credit funds cannot trade in and out of company debt in the secondary market, leaving them strapped in for the life of the loan.

With private credit still in high-growth mode, some on the traditional bank lending side believe the true test will emerge once growth slows and these funds absorb a loss, publicly

“If a few starts to lose money, investors in direct lenders will ask questions. For things to change we need to see some of these credits go bad,” a senior banker said.

DOUBLE-EDGED SWORD

Since the financial crisis, the growth of private credit has come at the expense of more traditional lenders such as banks, but direct lenders depend precisely on such firms to provide day-to-day liquidity for their lending models.

The subscription lines and leverage facilities that direct lenders funnel from banks allow them to quickly respond to borrowers and remain competitive on pricing individual deals, which is paramount in the white-hot market of leveraged finance.

Last year, BDCs scored a big win when the US government relaxed leverage restrictions, which opened the door for the funds to secure extra liquidity from the banks.

Since then, BDCs have seized on an opportunity to use the financing to position themselves into less risky, first-lien assets as the prospect of a downturn becomes a closer reality.

In the latest round of earnings, leverage levels have spiked among some BDCs. Fitch Ratings affirmed its negative outlook on the sector in October.

“There has been a recent decline in middle market covenant-lite volume; however, we expect pressure on terms to continue, which could ultimately lead to weaker recoveries on problem assets when the next credit cycle materializes,” said Chelsea Richardson, associate director at Fitch Ratings.

Private credit funds and BDCs have sought to diversify their funding sources since the financial crisis. They are not reliant on a single source for funding and regularly seek baby bonds in addition to revolving credit facilities to provide ample liquidity should banks want to pull back on funding.

“It didn’t happen in the last financial crisis. Most BDCs only had a revolver. Now the revolver is only a smaller part of the BDC’s liability stack, so it’s generally pretty insulated,” an analyst said. “Though if a bank is pulling the revolver then we’re already pretty far down in the rabbit hole.”

BRING IT ON

Unphased by the uncertainties surrounding the asset class, private lenders believe they are well-placed to safely ride out a downturn.

Some argue the intimate, club-like nature of these deals has the best interests of both parties in mind as direct lenders are married to the borrower for the life of the loan.

“There is a closeness to the borrower. Private credit funds own the loan and are there till the end. They behave as pragmatically as possible to preserve value,” said Jiri Krol deputy chief executive officer of industry group the Alternative Credit Council.

And while private credit primarily plies its trade with middle market borrowers, there is little doubt they are increasing their market share among larger, broadly-syndicated loans.

“There are going to be winners and losers. There’s been talk of a recession for years. We’re not afraid of it. Going through the cycle is the real acid test,” said Garrett Ryan, partner and head of capital markets at direct lender Twin Brook Capital Partners. (Reporting by Aaron Weinman and David Brooke. Editing by Michelle Sierra and Kristen Haunss)