A piece of the pie: Special report on direct lending

Everybody seems to want a piece of the direct lending market at the moment. But as a multitude of new opportunities hit the market, investors should be prepared to up their due diligence, Kathryn Gaw reports…

Direct lending is arguably the hottest segment in private credit right now. According to a recent report from Allianz, it is direct lending that has fuelled the impressive growth of the private debt market over the past five years, and its impact is set to continue for the foreseeable future.

Earlier this year, JPMorgan’s 2024 Long-Term Capital Market Assumptions report suggested that direct lending would likely deliver annual total returns in excess of 8.5 per cent over the next 10 years, with even higher returns predicted for the year ahead. While default rates are expected to rise, JPMorgan noted that investors will be “well compensated” for this risk.

However, direct lending’s rapid growth has inevitably resulted in fierce competition for deals. The more established direct lending fund managers are securing the majority of market share, but they are increasingly facing pressure from both the upper and lower ends of the market, as investment banks and new direct lenders begin to push into the space.

Meanwhile, a lack of deal activity and an abundance of capital has highlighted the importance of active fund management and strong networks, leading to a bifurcation in the ever-popular mid market. Earlier this year, Morningstar DBRS reported that issuers rated CCC (high) or lower now represent six per cent of its portfolio – up from two per cent at the end of 2022, with downgrades outpacing upgrades by 2.6 times in the first quarter of 2024. However, the credit agency also noted that the upper end of the market was thriving, indicating an emerging schism in fund quality.

This variation in direct lending funds has underlined the importance of active portfolio management, sector expertise and detailed investor due diligence.

“Ultimately, private credit is about people and trust and expertise,” says Alex Di Santo, head of private equity, Europe, at fund administrator Gen II.

“We’ve seen a lot of people hear about the success of private credit and try and move into that space. But if you don’t have the expertise and the right team to be able to deliver that, it’s very difficult. It’s a very different skillset, and a very different type of arrangement.

“It takes time to build that infrastructure and build those networks. If you take a couple of key people out of those businesses, it could all fall apart quickly.”

Established private debt funds have an advantage in this space, as they have the connections and the track record to secure deals before their competitors even know that they exist. However, even established private credit players are learning that direct lending is a uniquely challenging segment.

In October 2023, Fidelity International launched its first direct lending fund in Europe and closed its first deal – a senior financing agreement with the Clinias Dental Group based in the Netherlands.

Yet just seven months later, the firm confirmed that it was exiting the direct lending space altogether, following the departure of Andrew McCaffery, the firm’s long-standing co-chief investment officer for fixed income, multi asset and private assets. Fidelity declined to comment to Alternative Credit Investor when approached for additional information on the exit from direct lending.

Even the largest banks are finding that it is not easy to enter this space and maintain their market share. Banks typically prefer to make larger loans to investment grade borrowers, but over the past few years, private credit fund managers have been inching ever closer to this once-impenetrable territory.

Read more: Ares, Eurazeo and Goldman top European direct lender rankings

“Direct lenders are more willing to compete on pricing to win lower levered senior deals, where banks have typically focused,” explains Tim Warrick, managing director of alternative credit at Principal Asset Management.

“We are witnessing significant delineation across the direct lending market, with large firms oftentimes moving more ‘upmarket’ in order to deploy the significant capital they have raised.

“This drives increased demand for larger deals and puts the upper middle market and larger private credit market in direct competition with the public high-yield market.”

In recent years, banks have shown a greater appetite to partner with private credit funds on these upper mid-market deals, raising the possibility of increased collaboration or even consolidation in the near future, as the demand for direct lending opportunities grows.

Read more: Apollo exec forecasts rise in hybrid bank/private credit deals

“Massive pockets of capital have come into the space,” says Adam J. Weiss, managing director of credit at Petra Funds.

“Many banks such as Wells Fargo and Barclays have partnered together for direct lending and private credit pushes. There’s also been a large increase lately in the registered independent adviser channel looking to go into private credit as well.”

For now, all of this excitement is creating something of a bottleneck. The number of M&A transactions fell by 15 per cent last year compared with 2022, which has limited the number of deals available to direct lending managers. This has led to an environment where there is more capital but fewer opportunities to deploy it, intensifying the competition for new deals.

Furthermore, most fund managers appear to be focusing on the same direct lending segment of mid-market deals.

Last month, Principal Asset Management launched the Principal Private Credit Fund I, offering exposure to lower and core middle market loans. And Pemberton Asset Management recently revealed that it is looking to raise more than €4bn (£3.4bn) for the fourth vintage of its mid-market debt fund.

However, there is enormous variation in the mid market. The mid-market is typically defined as funds which cover deals worth between $50m and $100m. In the upper mid-market, private debt funds are competing against global banks for the best quality deals. But towards the lower end of the mid-market, smaller and newer lenders are seizing their chance to steal market share from the bigger players by offering more flexible lending solutions and covenant-light deals in order to secure new contracts.

“That has been a slowly developing trend over the past few years,” says Di Santo.

“People are thinking of more novel ways and more flexible ways to offer these type of products, and I think that will continue for sure.”

This is a particular issue with deals which were originated between 2020 and 2022, as they were underwritten with higher leverage when interest rates were at an all-time low. As some of these loans approach maturity or seek refinancing, weaker businesses may struggle to afford the new rate of interest, which can increase the risk of a default.

“This is why the reporting is so important,” says Di Santo. “You need to make sure you’re getting weekly reporting on those loans. Due diligence is massively important in that process.”

In direct lending, the key risk is that the underlying borrower will be unable to repay the loan within the agreed term time. If refinancing solutions cannot be agreed, fund managers may have to resort to calling in collateral or accepting a lower value to close off a troubled deal. This makes due diligence extremely important for fund managers and investors alike.

“This paradigm has caused stress in the market for those who may be in a position to have to refinance, making the process more costly as well as extend duration,” says Jason Meklinsky, chief revenue and strategy officer at Socium Fund Services.

Meklinsky believes that bigger lenders such as established private credit fund managers and investment banks are in a better position to weather any potential default risk than smaller lenders.

“The larger lenders have a bigger set of opportunities to lend to and can often hold themselves to higher lending standards,” he says. “The smaller lenders may have to take on more risk to acquire their ‘optimal’ portfolio.”

Read more: Direct lenders look to non-sponsored market

However, this may be merely a temporary issue for the sector. There are some early signs that the lending environment could improve by the end of this year. Most economists believe that the Bank of England will finally start to make cuts to the base rate in August, which will ease the pressure on borrowers and should lead to a boost in funding requests. Meanwhile, a number of industry insiders told Alternative Credit Investor that they expect transaction activity to pick up towards the end of the year, with an increase in the pace of leveraged buyouts and M&A activity. This suggests that the current deal drought could soon come to an end.

“Though risk premiums have compressed somewhat for direct lending, we believe the value proposition for investors will continue to be attractive as public market risk premiums are quite compressed,” says Warrick.

“In addition, lower middle market and certain core middle market direct lending opportunities continue to provide attractive credit structures, with reasonable leverage and covenants, in addition to relatively attractive pricing compared to larger transactions.

“We believe direct lending remains in the relatively early stage of what will be continued growth for years to come.”

Investor demand for direct lending funds is only getting higher, so for fund managers the challenge will be to meet this demand without risking the reputation of the sector by accepting lower quality loans at unrealistic rates. Manager expertise has never been more important, at least until deal activity picks up and economic conditions improve. Until then, the competition for quality will make this a particularly interesting private credit segment to watch.