In this article:
Direct lending is about to enter its most difficult period in the 25 years I’ve been in the market. After years of exuberant growth, today the asset class is evolving into something very different and altogether more challenging, thanks to looming higher default rates, broader weakness across existing portfolios, and a pickup in consolidation across the space.
The shift marks what I see as the third era of the direct lending market. The first generation came after the bursting of the dot-com bubble in 2001-2002, when the first wave of private funds emerged to compete with the banks that had traditionally dominated this space. This launched a massive expansion across the market right up until the 2008 global financial crisis, albeit primarily focused on the US.
The second stage in the evolution of private lending came in the wake of the GFC, as the broad risk-off environment and increased regulatory burden on banks pushed them away from corporate lending. This prompted a long stretch of growth, particularly in Europe after funds started raising capital there in 2009-2010. This is when the direct lending market for closed-end funds really took off.
Over a similar period, the number of completed direct lending deals also soared.
While exciting, this second expansion hasn’t come without growing pains. The volume of capital that flooded the market meant that competition surged and, as we approach the end of this cycle, average deal sizes have grown. Although returns generally stayed strong, some terms available to investors, such as debt/EBITDA covenants on offer in most lending agreements, have weakened.
The next generation
So why may this next phase of the direct lending market’s development be more complex and more interesting? Partly because I believe we are likely to see a step-up in the number of borrowers facing pressures or even defaulting on existing facilities underwritten in more generous times.
Over the last few years, default rates have stayed low and recoveries have been strong. But today, soaring rates and weakening economic backdrops are turning the screw on some private credit borrowers. Given that many of the existing facilities were priced at the height of growth in the market, binding borrowers with high leverage levels and expensive debt, they’re now facing drastically higher interest costs that could push to the brink those firms that don’t have strong cash-flows or which have taken on excessive leverage.
This leads us to the second big change that I expect: as defaults creep higher, loss rates on some existing portfolios will rise, and some managers will start to struggle. During the most exuberant days of the boom that followed the GFC, some managers were able to get by – or even to flourish – without taking a particularly stringent view on the credits themselves. But those days are coming to an end, particularly once the higher interest rates and funding costs of floating rate direct loans really start to hit borrowers’ bottom lines. The next era will demand more stringent analysis, and a more exacting approach to credit work and to investing as a whole.
This is not all bad news of course. If the rising tide lifts all boats, a difficult environment gives stronger strategies an opportunity to distinguish themselves. As the market bifurcates further, I expect fund consolidation across Europe as some stronger managers snap up their weaker rivals’ positions.
But this is not to say that the market is set to contract; in fact, I believe there is still capacity for the European direct lending market to get even bigger. A lot of the current investment focus may be on the healthcare, finance, and services sectors, all generally strong cash flow producing business models, but we expect to see this list expand as industrial borrowers reappear.
Similarly, although direct lending has become more widely accepted as a financing product in countries such as the UK, France, and Germany, there is still room for the asset class to expand in markets such as the Netherlands and other European jurisdictions as they see the value of direct lending. Looking beyond Europe and the US, the next phase of direct lending may target Asia, where the granularity of lending across the different countries has impeded growth up to now.
A growing familiarity
One of the key changes in the private credit space since the GFC is how familiar direct lending has become to many players across the market. Even though it’s been around for quite some time, it’s only recently that direct lending has become an established asset class, especially in Europe.
Sponsors in particular are more comfortable using direct lenders, and the proportion of leveraged buyouts funded via this market has exploded in recent years. During this period of growth, direct lending has come to make up the majority of overall financings across private equity driven transactions.
Similarly, the market has become more familiar and accepted by investor limited partners. With the appeal of the consistently stable cash yields on offer alongside low volatility and low defaults, an increasingly sophisticated investor base is becoming more comfortable allocating to it. There has been a surge of pension funds entering the European market, while insurance companies - attracted by the solid returns on offer, alongside the fact the reporting here takes into consideration Solvency II obligations- are likely to become increasingly important players.
As the investor base grows and larger pools of capital become involved, this could prompt even more changes in the market. Regulators could begin to focus on the asset class as it becomes a mainstream part of the corporate financing market, while a greater demand for transparency could drive managers to be more open in their reporting.
The arrival of more investors probably also means more liquidity in the market. Already some small-scale trading is emerging in Europe (albeit of secondary LP stakes rather than of the individual loans themselves). In a few years’ time a more liquid trading market could mean assets in the space begin to be valued on a mark-to-market basis, rather than at their historical cost as they are now.
Some of these predictions, of course, are more speculative, but if realised they would completely revolutionise this asset class within the next few years. I've watched this asset class grow and evolve over the last thirty years, from its infancy to the cusp of mainstream. The future promises a market that is fundamentally more grown-up, with a more sophisticated investor base. But managers and investors alike should be clear about the challenges this brings.