With the markets for syndicated loans, high-yield bonds and CLOs still dislocated due to economic turmoil and the increasing possibility of a wave of defaults, direct lenders' moment in the sun has arrived.
There is certainly lots of money to be made for such funds – in particular when it comes to taking advantage of the poor (at least in hindsight) underwriting decisions taken by their banking rivals in the syndicated lending business.
The banks, stuffed to the gunnels with stuck loans, are desperate to offload that paper and often their only option is to turn to the direct lenders flush with cash to put to work.
"The conversations that are being had around hung deals within banks … they are talking to all the direct lenders. There's been so much money raised in the last two, three years, that dry powder is ready to be deployed," said Jeff Boswell, head of alternative credit at investment manager Ninety One.
Boswell points to the multi-billion dollar sizes of the funds that have been raised by direct lenders. "They have the cheque book to help out and at better economics than [would be available in] public markets," he said.
Armen Panossian, head of performing credit at money manager Oaktree, agrees. "I do think that the direct lenders will team up with the banks; they will buy those loans at discounts to where the banks had underwritten them," he said.
But the direct lenders will drive a hard bargain. "They will be able to take some of the hung loan paper down but when they smell blood they are like any other investor – they put in a low-ball bid," said one senior European debt banker.
And yet, while the direct lenders are in the middle of an unprecedented opportunity to make money, there is a reason that that paper is on offer at large discounts. And direct lenders need to be wary of getting carried away – especially when there is so much competition in the space and when there is not enough traditional deal flow for direct lenders' to use the considerable dry powder they have amassed over several years.
"The worst phase for investors in a particular sector is too much capital chasing too few deals. And that's the dynamic that is happening right here," said Justin Guichard, a co-portfolio manager at Oaktree.
Indeed, so much capital has made its way to the direct lending world that the players involved have undergone significant transformations. Sponsor-oriented direct lending business was historically a mostly middle-market theme. Not any longer. A fact underlined by Ares comfortably writing a €1bn cheque as a direct lender in the case of the recent LBO of financial news outfit Euromoney.
The competition is one reason why pricing on offer from direct lenders has failed to adjust as decisively as pricing in the public markets. "There's a lot of capital focused on corporate direct lending. And that capital is just not repricing fast enough to keep up with what's happening in the traded securities market," said Guichard.
Direct lenders have traditionally charged a 150bp illiquidity premium relative to public markets, as compensation for the fact that they will hold the paper come what may. But that premium is hard to spot when direct lenders are currently charging a spread of 575bp–675bp over Euribor even as market-clearing pricing in the leverage loan and high-yield markets has moved much wider.
The scale of these direct lenders has grown to such an extent that investment banks are starting to consider how to respond. Rather than just being an exit route, the big banks have concluded, these direct lenders are shaping up as a threat to the bottom line.
JP Morgan has said it is establishing an in-house direct lending operation, using capital the bank has already allocated to the speculative-grade space, highlighting the impact of the direct lenders.
"It might be a challenge for the upper and middle market direct lenders; it is going add another competitor and this is a fierce one," said Eric Gallerne, a managing partner for private debt at Eurazeo, although he adds that Eurazeo – which has been an alternative lender for 15 years – is seeing relatively little competition in the lower and middle market segment in which it operates.
"It illustrates the mega trend. It is structural now. Direct lenders are dominating the market especially in the LBO financing segment and I don’t see that changing right now," said Gallerne.