What is Private Debt / Direct Lending?
Direct lending, private debt, private credit, private lending, illiquid credit and alternative credit are sometimes used interchangeably for bespoke, structured credit offered by non-bank lenders – going directly to the borrower.
As the group of lenders is either a small consortium or just one counterparty, terms are commercially sensitive and withheld. Additionally, since there is not a traditional syndication process or bank capital provisioning considerations in place, terms can be off-market versus standard bonds and syndicated loans as they are tailored to the needs of the direct lenders and the borrower. Lenders will also be able to generate more comfort in the loan owing to the enhanced due diligence they can conduct inside the tent (insider information).
So while traditional bank loans may be seen as rigid, private debt is extremely flexible and can be highly structured and anywhere on the capital structure / priority waterfall. In return for looser covenants, longer tenor or other borrower desires, private lenders are able to sweeten their own yields through a variety of creative solutions on top of traditional cash pay interest – with upfront fees, LIBOR floors, or warrants.
Direct lending as an asset class is growing, with private equity sponsors, commercial projects and real estate increasingly looking at direct lending as a source of capital – especially with traditional banks retreating from certain exposures.
Sometimes, direct lending refers only to non-bank lenders or alternative asset managers lending directly to small and medium enterprises (SME) and bypassing traditional banks. This is also sometimes called middle market lending or middle market direct lending.
However, a lot of private debt is not on a bilateral basis – although there will usually be one or a few anchor investors that hold the largest amount of the debt and will usually be relied upon by the other private debt investors piggybacking their due diligence process and following along on their negotiation of key covenants and other loan documentation issues.
Direct lending is increasingly being used in a wide range of corporate finance activities, ranging from leveraged buyouts, acquisition finance, dividend recapitalizations and organic expansions. The structured nature of the product is attractive to financial sponsors while being a much cheaper alternative to equity and equity-like securities and accordingly shortening payback and enhancing IRRs.
Direct Lending as an Asset Class
Direct lending has become attractive for buy side participants because of the high absolute returns as well as risk adjusted returns. Direct lending has historically yielded an attractive Sharpe ratio relative to high yield bonds, leveraged loans and equity across business cycles (bonds tank when the credit cycle goes bust).
In addition, direct lending and private debt usually provide greater lender protections via covenants. Structuring also allows for other lender comforts including amortization and mandatory cash sweeps. As with other loans, interest tends to be floating.
Returns on private lending are generally high single digit to low / mid double digit – with returns approaching 20% IRR if subordinated / equity-like. For smaller firms, borrowers will pay a premium on their yield owing to them being too small to tap into debt capital markets.
However, compelling economic returns have induced additional capital to flow into the direct lending / private debt market, so spreads have tightened and will continue to tighten over time.
Similar to LBO candidates, attractive borrower candidates have an economic moat, strong levels of free cash flow, forecasted top quartile revenue growth, a sponsor with sufficient at-risk capital, appropriate leverage, strong management team and low cash flow volatility (non-cyclical).
The drawbacks that direct lenders face is that the debt is illiquid (hence the name illiquid credit) and difficult to exit. Additionally, should the loan fail despite the various covenant protections negotiated the aforementioned issue requires operational know-how or workout experience, which not all lenders may have.
Direct Lenders / Private Debt Investors
Institutional investors looking for direct lending / private lending exposure include hedge funds, insurers, pensions, credit funds, funds of funds, illiquid credit arms of alternative asset managers (including those primarily known for private equity), endowments, family offices, private banks (on behalf of their HNW clients) and other financial institutions. Direct lending has become increasingly compelling for fixed income asset managers starved for yield.
However, more and more money flows to established alternative asset managers instead of have not asset managers, with new entrants finding it more and more difficult to raise capital while incumbents aggressively look to deploy capital (dry powder) to earn their management fees.
Different investors will look at different direct lending opportunities across the seniority spectrum. Investors in the first lien (1L) or senior debt with a priority lien or first charge on substantially all assets of the borrower will look at the total collateral or enterprise value of the firm.
2L and subordinated lenders have less collateral value to depend on and will look more at the ability of the cash flows of the borrower to service debt. If there are multiple tranches to the debt solutions higher returns will be required.
Unitranche is also a common private lending option, offering borrowers an all-inclusive solution will possibly lower all-in interest costs while affording lenders with better control and covenant discretion.
Historically, private debt has been extended to real asset industries such as infrastructure or commercial real estate, but as investor acceptance grows, the list of industries is expanding as well in terms of private debt exposure.
Private Debt Investment Process
Private debt investors may have many proposals and opportunities to invest thrown their way.
When initially presented with investment opportunities, a preliminary evaluation must be conducted by the investment team and senior management for criteria such as credit quality, fit for investment mandate and return profile. For example, if a fund looks for low double digit returns and avoids certain industries, an oil and gas loan yielding 9% would be passed on.
If there is an opportunity that interests the private debt deal team, a more fulsome review of the investment opportunity will occur. The investor will conduct a thorough due diligence review of historical operating and financial information and build operating and financial models that evaluate debt service. They will also conduct industry analysis to review the credit’s relative position on the cost curve and competitive advantages. Interviews will be conducted with the management and financial sponsor with possible operating site visits (factory, oilfield).
A few more weeks down the road the deal team may socialize the opportunity with the investment committee (IC) – discussing the due diligence conducted, fit in the portfolio given risk and reward. On the risk side this may be exposure and potential loss and then a business side evaluation using relative value analysis.
At this point there may be a preliminary, non-binding term sheet furnished and initial negotiations commencing with the potential borrower. Due diligence is completed, including channel checks and third party consultants being hired (environmental, industry, legal, region) while potential issues are contemplated. A final form investment memo is sent to committee for the green light decision.
Ultimately, similar to private equity, private debt investors may only invest in 1 in every 20 opportunities over a multiple month process.