With corporate banks seemingly reluctant to lend to anyone but big blue-chip firms, and businesses seeking greater access to financial support post-Covid, direct private lending is ready to seize the opportunity for growth
The past decade has undoubtedly been a golden era for private equity. And now, it seems, private direct lending is set to enjoy its own moment in the sun.
Private direct lending is any kind of credit extended to companies by lenders other than banks, and includes debt classes such as mezzanine, real estate, distressed, infrastructure and special situations.
Direct lending funds have already taken a significant slice of the lending pie in the wake of the global financial crisis. Now, they are poised to extend their reach further – particularly into sectors where companies are facing distress and corporate restructurings following the pandemic.
However, with that will come a new set of challenges – as funds will need to establish effective ways to manage the increased risks posed.
The growing popularity of private debt among investors is already well evidenced. Alternative assets data provider Preqin estimates that in Q2 of 2021, private debt funds worldwide were sitting on $364bn of dry powder – capital raised but not yet deployed.
The number of private debt funds has more than doubled since 2017, says Preqin. And it’s direct lending that’s generally leading the charge.
According to Preqin, direct lending funds represent 53% of the funds in market and 56% of the capital being targeted in private debt, while the proportion of investors targeting private direct lending has risen from 38% in Q2 2020 to 68% a year later.
A key contributing factor to the rise in direct lending, first in North America and now increasingly in Europe and elsewhere, is the general trend of banks de-risking their loan books, resulting in a perceived growing reticence of banks to lend to all but the most ‘blue-chip of companies’.
Andrew Boyce, a Corporate Partner at Carey Olsen in Guernsey, believes the global financial crisis provided much of the current impetus.
“The period immediately prior to the financial crisis was a ‘boom period’ of available credit, resulting in somewhat borrower-friendly lending terms,” he says.
“Examples of this were cheaper pricing and ‘covenant-lite’ loans. So, competition to be able to lend was eroding the usual lender protections.
“The financial crisis exposed the dangers of a surplus of available credit and, with the post-financial crisis contraction in available liquidity, the banks – simply put – didn’t need or want to be taking those risks anymore,” he explains.
“The banks have, to an extent, all started chasing similar clients – larger, well-known, financially stable ‘blue chip’ companies. That has inevitably left a bit of a gap.”
The rise of direct lending, adds Boyce, has seen private debt move from ‘the fringes’ – secondary areas such as mezzanine and junior level credit or more esoteric types of credit lines – to providing senior frontline and mainstream debt.
“Direct lenders have provided much needed competition in the credit space and stepped in to the banks’ accustomed positions in many situations,” he says.
Target audiences
Direct lending is generally targeted at mid-sized companies the banks typically shy away from, but which still require significant lines of credit.
The size of loans would typically be between £20m and £500m, says Alan Booth, Global Head of Capital Markets at Ocorian.
“If we look at the global corporates that might have a bit of stress, they have their own credit facilities with the banks that they can draw down on, albeit they’ll pay a little bit more,” says Booth.
“But it’s companies that wouldn’t have access to those kind of robust credit facilities with the banks that present an opportunity for direct lending funds.”
From an investor’s perspective, the appeal of direct lending is the opportunity to achieve higher levels of return than can be obtained from cash or fixed-rate securities. “What we are seeing now is that cash is relatively freely available, it is cheap,” explains Booth.
“But in this low interest rate environment, the return on keeping cash on deposit is minimal. If you’re holding euros, you’re in negative territory. So it’s a case of deploying that cash in the most appropriate way and getting the returns that you want.”
Change of emphasis
Other asset classes, such as UK real estate, which were providing reliable returns of up to 30% each year, have also dampened considerably. So investors such as pension funds, insurance companies and sovereign wealth funds have turned their attention to direct lending.
Ocorian’s recent global survey of capital markets investors found that 87% are pursuing direct lending opportunities either through an existing strategy (57%) or a new strategy that they are in the process of executing (30%).
And direct lending proved to be the most popular strategy for private capital funds closing in 2020, accounting for 56% of all funds closed in Europe, according to Deloitte’s Alternative Lender Deal Tracker, Spring 2021.
Booth says that while much of the economy has weathered the storm of Covid-19, certain sectors have been harder hit. Once government support such as the furlough scheme is withdrawn, companies in these sectors will provide a vein of opportunities for direct lending in the months ahead.
“For example, aviation and maritime transportation sectors, as well as high-street retail businesses, have all had sizeable impacts,” says Booth.
Already indebted companies may seek options such as mergers and acquisitions, debt restructurings, securitisation of assets and even insolvency. Because of the distressed nature of these companies, the returns on offer will be especially attractive.
However, with that will come a note of caution. The investors surveyed by Ocorian acknowledged lack of confidence in their own ability to manage these situations.
They expressed the least confidence in addressing loss recoveries (47%), risk assessment (53%), statement production (54%) and covenant monitoring (57%).
What that means, says Booth, is that those who are stepping into this space for the first time may need extra support in running their operations.
“Our view is that fund managers need to be unshackled from the day-to-day operations so they can focus on executing on the investment strategy,” he says.
The advantages of establishing private debt funds in the Channel Islands are much the same as those for establishing any financial structure in Jersey or Guernsey, says Boyce.
“It’s the international standard regulation, the flexibility of the vehicles, the tax-neutrality, and the experience and the knowledge of the service providers here – we’ve been doing this for 30-odd years.”
He points out that bigger private credit funds – run by the likes of the large private equity sponsors – have extremely sophisticated operations and will be quite capable of dealing with a more challenging environment.
“The risk is the same as when there is a bank lending, because at its heart it is about understanding who you are lending to and what the specific financial tolerances are.
“Where there’s a crisis element, there’s always some risk of default,” he says. “But in some ways, direct lenders are in a better position to effect recoveries because they can be more flexible in how they approach a default scenario.”
Positive outlook
Booth says the outlook for direct lending is extremely positive, not least because it will be an attractive option for investors, given the likelihood of continued low interest rates.
“What we can see in the next three to five years are great opportunities for direct lending,” he says. “For those assets that are more distressed, direct lending will increase because we’re in a low interest rate environment.
“And it’s going to be a focus of all the central banks to maintain that low interest rate environment, because there’s been a lot of government borrowing.”
Banks will eventually lend more, says Booth, but the market has gained confidence around the agility that private direct lending can offer.
Booth concludes: “I see direct lending certainly being the dominant player in terms of any form of lending for corporates going forward.”