What is direct lending?

Direct lending is a form of private credit where non-bank lenders provide loans directly to companies, typically in the middle market. It has become an increasingly important source of financing, especially as traditional banks have become more conservative in their lending practices.

The direct lending market has experienced significant growth over the past decade, becoming an increasingly important part of the private credit landscape. In recent years, direct lending has expanded its scope, playing a significant role in financing various transactions such as leveraged buyouts, refinancing, and follow-on investments.

This growth trajectory is expected to continue, with Preqin predicting that direct lending will remain the most popular strategy in private capital fundraising in the coming years.

What are the benefits of direct lending?

Direct lending offers several benefits in the current financial landscape:

1. Attractive returns: As of August 15, 2024, direct lenders are earning a premium of 100 to 150 basis points over the syndicated market, with the best-quality deals priced between 475 to 525 basis points over SOFR.
2. Flexibility: Direct lenders can provide more tailored financing solutions, especially for deals in niche currencies like Swiss francs and sterling, where syndicated markets are shallower.
3. Execution reliability: Particularly in sterling-denominated deals, direct lenders often offer more consistent execution, making them a preferred choice for M&A financing in the UK
4. Competitive leverage levels: As of March 8, 2024, direct lenders are able to offer higher leverage levels compared to banks, with some pitches reaching just under 5x leverage for mid-market buyouts.
5. Increased deal flow: The U.S. direct lending market has seen rising activity, providing more opportunities for lenders to deploy capital.
6. Strong investor interest: As of March 22, 2024, 67% of investors surveyed identified direct lending as presenting the best opportunities in private debt, up from 54% in 2022.
7. Advantageous position in specific scenarios: Direct lenders have an edge when there’s a need for undrawn acquisition facilities, when a borrower requires extra leverage, or when a PIK element is needed ⁶. These benefits have contributed to direct lending’s growing prominence in the financial market, competing effectively with traditional syndicated debt markets and providing valuable options for borrowers across various sectors.

What are the risks associated with direct lending?

1. Liquidity risk: While liquidity risk in the private credit market appears low due to the closed-end structure of most funds, semi-liquid perpetual and private BDCs offering limited redemptions could face challenges during sustained periods of stress.
2. Interconnectedness with banks: The rising interconnectedness between private credit funds and banks through capital call facilities and revolving credit facilities poses potential risks, although it’s difficult to accurately measure due to lack of data availability
3. Default risk: In a severe recession, a spike in private credit default rates could lead to financial instability. Struggling portfolio companies might tap undrawn portions of their revolving credit facilities, forcing direct lenders to draw down their own facilities with banks, potentially creating a “dash for liquidity”
4. Valuation uncertainty: Loan valuations in private credit are inherently not transparent and subject to uncertainty. A sharp drop in these valuations could result in banks demanding margin calls from private credit funds and BDCs.
5. Operational risk: Direct lenders face operational risks due to decentralized branch-led disbursements and customer-related processes.
6. Competition from banks: As of March 15, 2024, a main concern for direct lenders was banks winning deals back as the BSL market reopens.
7. Distress management: As of November 3, 2023, many direct lending funds, particularly smaller firms, lacked the necessary resources to handle the challenges of restructuring in cases of distress.
8. Rising defaults: As of October 12, 2023, the prospect of rising defaults was a top concern for limited partners in private debt 5.

Learn more about direct lending, and Octus’ coverage of the private credit & direct lending space here.

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