Direct Lending: The Current State of private Credit
The past decade has been a challenging one for Wall Street’s investment banks. The once-vaunted titans of corporate finance have struggled to adapt to a post-financial crisis reality, as regulations like the Dodd Frank Wall Street Reform and Consumer Protection Act have shrunk or eliminated key business segments. Aside from reducing their involvement in proprietary trading, ownership of hedge funds, and other risky activities, the post-crisis period has seen banks withdraw from certain segments of their most fundamental line of business: lending. In this void, direct lending funds have emerged as an alternative funding source for the corporate middle-market, an area in which large investment and commercial banks no longer deem it worthy to compete. These private credit funds pool money from institutional investors like insurance companies, endowments, and pension funds, and use them to provide direct loans to firms in search of capital (DeChesare). Although they originally emerged as a source of financing tailored to middle-market firms, direct lenders have since expanded to challenge large investment banks in one of their bread and butter businesses: financing large-cap transactions. Today, in an environment of rising interest rates and turmoil in the securities markets, private credit funds appear poised to take their insurgency to the next level, posing a significant threat to Wall Street’s underwriting hegemony.
Direct lending firms emerged largely in the aftermath of the 2008 financial crisis, as regulation of the financial sector and a variety of other factors made the financing of middle-market mergers and acquisitions (M&A) a less desirable space for large banks to compete in. In their early days, “these funds stepped in for regulated banks, [providing] small loans (say between $50 million [and] $200 million) to riskier companies that banks avoided, and often negotiated extras in their credit agreements like seats on their boards,” (Weinman, 2022). In addition to regulation, banks often chose not to participate in such deals because they fell in a “gray area.” When banks provide financing for large M&A transactions, they typically lend the capital to the acquirer themselves, then sell those loans to other investors in a process known as syndication. Middle-market transactions, however, are typically “too large for the bank to fund directly but too small to be worth syndicating,” (DeChesare). As a result, companies often choose to work with direct lenders, who can “fund the entire loan and complete the process quickly,” without a need for syndication (DeChesare). Driven primarily by post-crisis regulation and its occupation of this niche market, direct lending has experienced astronomical growth in the years since the 2008 financial crisis. Over this period, the assets under management of direct lending funds have grown by 800% to $800 billion in 2020 (Oaktree Capital).
As a result of their meteoric rise, direct lending funds have established themselves as key players in the post-financial crisis capital markets. Private debt, the broader strategy to which direct lending belongs, is now the third-largest private capital strategy, behind only private equity and venture capital (Ma et. al, 2022). Key to this change has been the expansion of direct lending strategies beyond their traditional home in the middle-market. Indeed, direct lenders now challenge the major investment banks in an area over which they were previously thought to have exclusive control: the financing of large-capitalization M&A.With private debt funds now “equipped with trillions of dollars in dry power,” direct lending strategies are “taking [large cap] market share from big banks more than ever before,” (Weinman, 2022). Recently, direct lenders like Blackstone Inc. have underwritten several high profile leveraged buyouts in excess of $1 billion, including The Carlyle Group’s $2.8 billion acquisition of the government contractor ManTech (Brooke et. al, 2022). Deals this size were once exclusively the province of large investment and commercial banks. Today, however, private credit funds are able to use their considerable assets to compete with those banks in winning financing mandates on multi-billion dollar buyouts. Having amassed $169.2 billion of dry powder – roughly 2.5 years’ worth – these funds will undoubtedly continue to pose a serious threat to Wall Street’s dominance of large-cap LBO underwriting.
Today’s rising interest rate environment and credit market turmoil appear to be the ideal conditions for direct lenders to thrive. In many ways, this turmoil has proven catastrophic for traditional banks who have underwritten leveraged buyouts in the past twelve months. The cause of this misfortune is simple. In the face of significant interest rate increases by the Federal Reserve, the interest rates on other types of loans, which use the federal funds rate as a benchmark, have risen as well. As a result, debt issued before the interest rate hikes began has a lower yield rate than debt issued after their commencement. In order to syndicate leveraged loans made in early 2022, banks must take larger write-downs on the loans’ face values in order to achieve yields comparable to those offered by debt issued later in the year (because debt prices and yields move inversely). This has led to enormous losses for a number of banks. One particularly notable example is the leveraged buyout of enterprise software firm Citrix by Vista Equity Partners and Elliot Management. The deal was finalized in January 2022, yet the syndication process for the debt used to finance it, underwritten by a consortium of large banks, took several months to conclude. When it finally did, the underwriters stood to lose more than $500 million, a direct consequence of rising interest rates (Saeedy and Cooper, 2022). Direct lenders, however, face no such syndication risk because they provide the financing directly, without the need to market loans to other investors (Weinman, 2022). As a result, these firms can continue to lend in the current rising interest rate environment, taking advantage of deals that banks are likely to forgo because of uncertainty regarding monetary policy. This positions them uniquely well to develop the expertise and relationships necessary to further challenge banks in large-cap LBO financing, even when interest rates start to fall.
References
Brooke, David, et al. “Private Credit Club Snags $2.9 Billion ManTech Buyout Debt.” Www.bloomberg.com, 17 May 2022, www.bloomberg.com/news/articles/2022-05-17/private-credit-club-snags-2-9-billion-mantech-buyout-debt?leadSource=uverify%20wall. Accessed 8 Oct. 2022.
Cooper, Alexander Saeedy and Laura. “WSJ News Exclusive | Citrix Debt Deal Prices with Large Losses for Banks.” Wall Street Journal, 21 Sept. 2022, www.wsj.com/articles/citrix-debt-deal-prices-with-large-losses-for-banks-11663769143. Accessed 8 Oct. 2022.
DeChesare, Brian. “Direct Lending Industry Guide: Industry, Funds & Careers.” Mergers and Inquisitions, 2020, mergersandinquisitions.com/direct-lending/#whatis.
“Direct Lending: Benefits, Risks and Opportunities.” Www.oaktreecapital.com, www.oaktreecapital.com/insights/insight-commentary/education/direct-lending. Ma, Cindy, et al. “Direct Lending Update, Spring 2022.” 2022.
Weinman, Aaron. “Private Credit Is so Hot Right Now, the Execs at SALT Were Raving about It. BlackRock and Owl Rock Are Taking Advantage of Banks’ Pain to Win More of This Booming Part of Wall Street.” Business Insider, 15 Sept. 2022, www.businessinsider.com/blackrock-owl-rock-private-credit-syndicated-loans-capital-markets-2022-9. Accessed 8 Oct. 2022.