By Fiona Hagdrup, Head of Investment Desk, Private Corporate Credit at M&G Investments
The direct lending market has expanded rapidly over the last few years with Pitchbook now estimating it accounts for around 50% of the wider $1.6 trillion global private credit asset class. The reason for this growth is well known, being largely the retrenchment of public lenders from certain credit segments, owing to capital and regulatory restrictions. However, direct lending is also an asset class which has proven to be dynamic and that continues to evolve. Significant change has occurred in terms of its structure, the competitive landscape with emergent factors shaping how investors are navigating this investment opportunity.
Here, we explore the most recent developments within the asset class and identify where we perceive the most attractive opportunities. Additionally, we will look at the increasing role of ESG and impact within the direct lending market and evaluate its growing importance in enhancing overall potential returns.
Price erosion
One of the most clearly observable developments within credit markets this year has been the renaissance of the broadly syndicated loan (BSL) market. For a year, following the underwriting stasis of banks in early 2023, as higher rates threatened certain business models, private credit funds filled a funding-gap for large leveraged buyouts. This underpinned a fundraising spree that might create deployment challenges and competition in the large-cap part of the market, now that the traditional funding route is available to sponsors and their investee companies once again.
As a consequence of buyouts being financed in the BSL market once again, competition amongst private credit lenders seeking to secure the largest deals has become fierce. In turn, this more competitive environment has led to an erosion of pricing (and terms) for these larger transactions. Not only have margins compressed but unwelcome documentary features like portability have crept in. Consequently investors that might previously have had a focus on the large-cap end of the market have migrated downwards in company-target-size in pursuit of more attractive margins and terms. Inevitably, this has led to greater lender competition causing a deterioration in pricing here as well. However, for the mega-funds, there is a limit to the size of company that can be targeted when deployment pressure is vast in absolute terms.
Consequently, while developments within the BSL market have impacted the attractiveness of parts of the direct lending universe for lenders, this is not universally the case. With stronger competition and deteriorating pricing being evident among larger sized borrowers, we believe there are still strong risk/reward investment opportunities in the lower-end of the mid-market. Pricing here remains stable and in our view may offer investors a better risk-return profile.
This shift in the competitive landscape has also impacted the relative attractiveness of some purported ‘senior’ loans. With historically high rates and a macroeconomic background that is uncertain, our preference would be to focus on more conservative direct lending opportunities versus unitranche which, being a hybrid of both senior and subordinated debt, has a riskier profile. The risk-return profile as well as the overall supply/demand dynamic currently, leads us to believe that the more conservative end of the market likely offers better value for investors.
Key differentiators: Volatility and price stability
The potential to deliver lower volatility/greater price stability relative to public markets, as well as high yield and BSL alternatives, may prove a key attraction for many investors. Whilst fixed income yields have certainly increased over the last 2-3 years, the higher yields seen within public markets can often be attributed to market dislocations. However these periods tend to be relatively short lived. By comparison, the typical longer-term focus of many direct lending investors together with the high cash coupons potentially available, has enabled the asset class to deliver high yields across market cycles demonstrating relative stability.
The chart below illustrates the favourable risk/return characteristics of direct lending, as measured by the Sharpe Ratio, compared to either high yield or investment grade credit:
Accepting the limited liquidity of direct lending will be an undeniable consideration for some investors, it is important to acknowledge restricted liquidity can also be advantageous. Attractive direct lending attributes such as security structure (normally senior positions), duration and credit risk are enhanced by the intrinsic liquidity constraints of direct lending which can provide a degree of protection during periods of significant market volatility or unforeseen market events. For investors, less volatile mark-to-market valuations relative to high yield and BSL lowers the risk factor when calculating risk-adjusted returns.
The floating rate nature of direct lending provides a further volatility advantage, particularly when compared to investment-grade bonds and high yield: low interest rate duration. Unlike these other credit options which expose investors to both interest rate and credit risk, the floating rate nature of direct lending ensures it is exposed only to credit risk and thereby lowering its volatility.
BSL and direct lending – competition or complement?
In periods of market turmoil the natural order can be upset, pitting direct lenders against broadly-syndicated investors. But, for the most part, particularly in Europe, the markets co-exist in harmony, each representing a stage in the maturity of a company’s evolution – from first buyout to eventual public listing.
Both markets appeal to different investors, borrowers and sponsors. The BSL market attracts investors looking for high diversification, steady running income and liquidity as well as a standardisation of process achieved by a large, formally-run syndication process by an arranging bank, while those looking to the higher yields of direct lending are prepared to tolerate the additional credit risk, greater portfolio concentration and locked-up nature of (most of) the strategies.
From a sponsor’s perspective the cost of debt will likely be lower in the BSL market, albeit with the time and expense of seeking public credit ratings being pre-requisites. Within direct lending, investors are usually rewarded with higher yields (‘illiquidity premium’) and sponsors can expect more nuanced discussions on transaction structures. Whilst the direct lending market has shown the greatest growth recently, the growth of both markets is positive and in a period of growing momentum in mergers and acquisitions (M&A), as we expect to characterise the rest of the year and beyond, symbiotic.
A shift in covenant and underwriting conditions
In addition to the impact on pricing, increasing levels of competition amongst credit providers has encouraged a more risk-tolerant attitude among lenders. Whilst above recent lows, the M&A market remains relatively subdued. This combined with lenders supplying a greater volume of credit has led to increased competition – the same number of lenders, with increased capacity, now chasing the same amount of paper. As a consequence there has been an observable loosening of lending terms. This is clearly evident when looking at levels of documentation protection and the fact that covenant-lite deals are now the norm at the large-cap end of the market.
This shift in risk tolerance is not exclusively a factor relevant to the larger end of the market. Even within the mid-market, covenant-lite deals are observed, with prudent lenders needing to question and re-evaluate the true value of the (tokenistic?) covenants that are being offered. Added to this are emergent structural features such as ‘payment-in-kind’ (PIK). Whilst offering lenders a higher potential return, PIK normally elevates risk with cash interest payments being deferred often owing to a borrower being too tight on cashflow to make the debt-servicing payments. It seems clear that the potential risks for end-investors are rising.
Perhaps the most important objective in lending is to avoid mistakes – particularly when a loan will be illiquid with no access to a secondary market. Within a market which has become more competitive, and more risk tolerant, remaining vigilant and assessing an opportunity through a cycle is paramount. In our opinion, in the current environment, being highly selective is key and should be prioritised over speed of deployment.
The impact of ESG within direct lending
Due to the nature of direct lending, typically with long lock-in periods, ESG integration is fundamental to resilient investment. As a longer term proposition, direct lenders need to consider the entire risk spectrum, and this includes ESG-related risks. Fortunately, with the necessarily close relationships enabled by a close nexus with management, direct lenders can feel confident that these risks will be identified and mitigated. Unlike public equity and bond markets, ESG data and disclosures as mandated by regulators can be less consistent and comprehensive.
Successfully integrating ESG within both the sourcing and portfolio construction stages can be strongly beneficial. During the sourcing process, assessment of ESG risk and its mitigation by company management can make resources efficient, less robust investment cases being easily filtered out. Then, strong ESG characteristics facilitates the construction of robust loan portfolios. As previously noted, risk mitigation is key within direct lending. Identifying possible ESG-related issues within a business and ensuring borrowers address them, is crucial particularly within an asset class with such an asymmetric payoff.
At the sourcing stage, potential ESG risk is something we think about as an ‘outside-in’ process – the prevailing risks of a sector and the mitigation measure taken to contain them.
This is a skilled undertaking as, unlike with public companies where much information is in the public domain, with private investments information is largely provided by company management and independent due diligence providers.
To be effective, this analysis needs to be done within a prescribed framework. The number of variables which need to be considered is expansive but with an effective framework in place focus can be brought in terms of geography, sector, business activity, sponsor. This type of analysis has become commonplace, a PRI survey in 2023 noting that 94% of general partners now use a defined ESG due diligence process.
Then, there is the consideration of ‘inside-out’ aspects of a company – its contribution to positive environmental or social characteristics and avoidance of any harm to either. The direct relationship that a lending connection brings is an effective tool of stakeholder influence in this regard. With the advent of regulation – notably on climate target-setting and biodiversity – a meaningful advancement in the average standards of private corporates may be anticipated if enough like-minded investors are exerting their influence on material sustainability themes.
The strong growth demonstrated recently within the direct lending market shows no signs of abating. This is unsurprising given its intrinsic attractions remain intact – reliable income streams, floating rates, diversification and potentially attractive risk-adjusted returns. However investors need to be conscious that this asset class is evolving and market dynamics are shifting. More than ever, it is important to adopt a highly selective approach with regards to selecting the level of loan seniority, or indeed the strength of lending terms. For these reasons we believe that the more conservative end of the mid-market is likely to offer better value for investors.
For Investment Professionals only. The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance.
