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Direct lenders ready for windfall as US economy cools

NEW YORK, Nov. 14 (LPC) – Private credit funds with deep pockets, capital flexibility, and rigorous investment are positioning themselves for the windfall that could follow if the U.S. economy cools down was expected to further reduce bank liquidity and investor appetite for broad loan syndication.

Banks, wary of an economic slowdown, have in some cases given up lending to companies perceived as riskier. Private investors, including private equity firms and business development companies (BDCs), are filling the void, siphoning cash from indebted borrowers in the absence of traditional sources of debt.

Private debt funds around the world raised US $ 110 billion in 2018 and US $ 129 billion in 2017, according to research firm Preqin. This year, even as leveraged credit activity has contracted, investors are expected to allocate more than US $ 100 billion to private credit funds.

“A lot of capital formation has been carried out, especially since 2008, in the area of ​​private credit. In many ways, these pools of capital, and we can choose our BDC, look forward to this volatility, ”said Dan Pietrzak, Co-Head of Private Credit at KKR & Co.

Direct lenders are well positioned to withstand an economic downturn as they are closed-end funds, which lock in capital unlike open funds, and do not face the same regulatory hurdles as banks, which still organize the lion’s share of lending. leveraged, are encouraged to.

Private credit pools also benefit from the opacity of the asset class. Loan documents are negotiated as a bilateral agreement or between a club of lenders, as opposed to a large syndicate which then cultivates debt between several institutional buyers. And in times of economic hardship, debt restructuring may be easier to negotiate within a tight-knit group.

“It may be easier to put everyone in a room and change the terms of a loan, while capital structures containing government securities may be less forgiving,” said Jonathan Insull, Managing Director of Crescent Capital. Group.

Direct lenders have become more important as Secured Loan Bonds (CLOs), wary of the end of the cycle, demanded better compensation for their risk when investing in Single B-rated, heavily syndicated trades that could fall into the market. the riskier territory of Triple C before a slowdown. CLOs, which are the largest buyers of institutional term loans, have limits on the number of loans they can hold with a Triple C rating.

Adding to the appeal of direct lenders, with CLO managers demanding higher interest payments and more protections, the syndicated market is no longer cheaper for borrowers. Throughout the fourth quarter of 2019, Single B-rated syndicated loans in the mid-market increased to an average yield of around 8%, down from around 7.4% a year earlier, according to data from Refinitiv LPC. And in September and October, at least 17 borrowers rated “Single B” saw the price of their syndicated loans higher than the initial terms of the offer.


Since the start of the year, at least 12 unitranche loans of over US $ 500 million have been issued by direct lenders, up from seven in 2018. In October, insurance broker Risk Strategies obtained a unitranche of 1 US $ 6 billion from 10 direct lenders, making it one of the largest such loans arranged to date.

While direct lenders have taken a larger slice of the pie, booming funds have yet to experience the headwinds of an economic downturn.

“These direct lenders haven’t been battle tested, so it’s hard to say how well equipped they are to deal with cyclical volatility,” said one portfolio manager who focuses on the mid-market.

Direct lenders need to be comfortable with the nature of buying and holding private loans. Unlike investors in an institutional B term loan, private credit funds cannot trade in and out of corporate debt in the secondary market, leaving them stranded for the life of the loan.

With private credit still in high growth mode, some on the traditional bank lending side believe that the real test will emerge once growth slows and these funds absorb a loss, publicly.

“If a few start losing money, direct lender investors will ask questions about direct lender loans via – direct lenders for bad credit. For things to change, we have to see some of these credits deteriorate, ”said a senior banker.


Since the financial crisis, private credit growth has come at the expense of more traditional lenders such as banks, but direct lenders depend on precisely these companies to provide daily liquidity to their lending models.

The subscription lines and leverage facilities that lenders direct to banks allow them to respond quickly to borrowers and remain competitive on the pricing of individual deals, which is paramount in the searing market for leveraged finance.

Last year, the BDCs scored a big victory when the US government eased debt restrictions, which allowed funds to obtain additional liquidity from banks.

Since then, BDCs have seized the opportunity to use the financing to position themselves in less risky senior assets as the prospect of a slowdown became a reality.

In the last round of results, debt levels skyrocketed in some BDCs. Fitch Ratings confirmed its negative outlook for the sector in October.

“There has been a recent drop in the volume of covenant-lite in the mid-market; however, we expect the pressure on conditions to continue, which may ultimately lead to lower recoveries of problematic assets in the next credit cycle, ”said Chelsea Richardson, associate director of Fitch Ratings.

Private credit funds and BDCs have sought to diversify their sources of funding since the financial crisis. They don’t depend on a single source of funding and regularly seek out baby bonds in addition to revolving credit facilities to provide sufficient liquidity if banks wish to withdraw their funding.

“This did not happen during the last financial crisis. Most BDCs only had a gun. Now the gun is just a smaller part of BDC’s liability stack, so it’s generally quite isolated, ”one analyst said. “But if a bank pulls the gun, we’re already pretty far down the rabbit hole.”


Phase-free by the uncertainties surrounding the asset class, private lenders believe they are well positioned to safely weather a recession.

Some argue that the intimate, club-like nature of these deals has the best interests of both parties in mind, as direct lenders are married to the borrower for the life of the loan.

“There is a proximity with the borrower. The private credit funds own the loan and are there until the end. They behave as pragmatically as possible to preserve value, ”said Jiri Krol, deputy managing director of the Alternative Credit Council industry group.

And while private credit primarily operates with middle market borrowers, there is no doubt that they are increasing their market share among larger, heavily syndicated loans.

“There will be winners and losers. We have been talking about a recession for years. We are not afraid of it. Going through the cycle is the real acid test, ”said Garrett Ryan, partner and head of capital markets at direct lender Twin Brook Capital Partners. (Reporting by Aaron Weinman and David Brooke. Editing by Michelle Sierra and Kristen Haunss)

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