An Analysis of the Rise of the Direct Lending Market

An Analysis of the Rise of the Direct Lending Market

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Posted
December 2, 2020
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In the wake of the 2008 economic crisis, the financial landscape has undergone dramatic changes over the past decade. This is largely due to the stringent regulations that were implemented in order to prevent future catastrophes. One ripple effect of such measures has been that traditional banks have become tighter with their purse strings and reluctant to lend. As a result, businesses looking for loans have sought out alternative avenues for investment and have chiefly found them in the form of direct lending.

Below, we’ll discuss why an increasing number of firms have jumped into the direct lending trend and what that could portent for the future of the financial lending market. Read on to discover more!

An Analysis of the Rise of the Direct Lending Market

What is Direct Lending and How Did It Come to Be?

The rise of direct lending preceded the financial collapse by several decades, but in truth, it was the tipping point. Over the span of years, commercial banks have become less willing to both originate and hold onto large amounts of debt (over middle-market companies). This is likely due to several factors, including:

  • Consolidation
  • Increased regulation
  • Lack of infrastructure

In the vacuum created by larger banks ceding their control of the lending market, asset managers—namely private equity funds and hedge funds—saw a prime investment opportunity wherein they would step in, raise money pools, and then act as if they were a bank. This was particularly intriguing for investors seeking:

  • Higher yielding debt
  • Floating rates
  • Lack of correlation to traded assets
  • Superior returns compared to liquid leveraged loans

How Does It Work?

Typically, the direct lending process removes the bank as an intermediary and consists of debt advisers making one of two pitches consisting of either loan and investment proposals, or mergers and acquisitions deals. From there, the direct lending funds conduct their own research until they find the right investment. Once made, direct lenders prefer to hold onto the loans on a long-term basis in order to yield the best results.

The typical buyer is what is known as a “mid-market business.” As discussed by the Washington Post, this group for middle-market lending is the optimal client because “their need for credit and lack of good alternatives means direct lenders have historically been able to extract higher interest rates — though reaching that higher yield is expected to become more challenging amid increased competition for business.”

Such asset management and lending practices have greater protections for consumers holding private debt since these loans will often include provisions such as:

  • More robust covenant packages
  • More transparent financial reporting
  • More frequent financial reporting
  • Longer amortization payments

This is also changing the dynamic of how investment returns can be generated. According to Private Debt Investor, “Private credit is moving from a period when returns were a product of idiosyncratic ‘alpha’ to an ear characterized by more cost-efficient direct lending beta-type performance stream.”

What Does the Current Market Look Like?

Today, the market opportunity for financing through direct lending is more appealing than ever for consumers and forecasts remain optimistic for portfolio companies, lenders, and consumers. Per one Ares report:

We believe despite the long duration of the current credit cycle, continued strong corporate earnings, low defaults, significant private equity dry powder and recent tax reform in the U.S. are drivers of a continuation of the current business cycle in the near term. In our view, the structural changes that have led to the emergence of direct lending as an established asset class remain firmly in place, with continuing macroeconomic trends supporting the current investment environment.

The same report states the most reasonable estimate of the direct loan middle market to be at $910 billion with expectations of reaching $1 trillion within the next two years. And, although the American market is an enticing one, the European market has far more room for growth since the total loans are only estimated to be around €120 billion. The reason for this being:

  • Nationalization
  • Bank consolidation
  • Regulatory pressure

Despite this, investment professionals and experts forecast that Europe will see a marked increase in direct lending thanks to centralized bank’s increasing reservations to take on such risk.

How You Can Improve Direct Lending Origination

If a private equity firm wishes to take advantage of these burgeoning markets and investment opportunities, they can’t simply wait around for debt advisers to approach them with the next deal. Similarly, direct lenders will not have as great of success without conducting the right research. Instead, both need to be proactive in the origination process.

That’s where SourceScrub comes in. Our platform helps PE firms stay competitive in the auction landscape or discover the founder-owned companies who haven’t yet come to market. It also allows Private Credit firms the chance to target those businesses who’d rather, at the current juncture, keep equity in-house and leverage corporate financing to expand growth capabilities. The AI-augmented, human-audited strategy relies on the power of both man and machine to leverage data in deal sourcing and churn out potential deals.

With SourceScrub’s help, financial lenders can take advantage of the rise of the direct lending market.  

Sources

  1. Private Debt Investor. How direct lending’s growth is changing returns. (2019). https://www.privatedebtinvestor.com/direct-lendings-growth-changing-returns-2/
  2. Ares. Opportunities in Global direct Lending. A Historical and Prospective View of the U.S. and European Markets. (2018). https://www.aresmgmt.com/media/458997/2018-Direct-Lending-White-Paper_vF-3-.pdf
  3. George, H. The Washington Post. Who Needs a Bank? Why direct lending is surging. (2019). https://www.washingtonpost.com/business/who-needs-a-bank-why-direct-lending-is-surging/2019/03/06/f3db0224-3fd5-11e9-85ad-779ef05fd9d8_story.html



Author
Josh Giglio

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