Direct lending is a form of private credit and refers to loans made by non-bank lenders to companies. As traditional bank lending has declined, direct lending by private equity firms has emerged as an alternative financing source for companies. There are several aspects that make direct lending investments appealing for investors: higher yields in a low yield environment, floating rate loans provide protection against rising rates, senior secured structures help minimize risk, and the private equity sponsor oversight provides an extra layer of due diligence. However, there are also risks including illiquidity, lack of standardization, and lack of track record. Overall, direct lending investments can provide portfolio diversification and opportunities not available in the public markets for suitable investors who understand the risks.
Direct lending investments offer higher yields compared to traditional fixed income
In a prolonged low interest rate environment, many fixed income investors have struggled to generate enough yield. Yields on investment grade corporate bonds, treasuries, and CDs remain low. Direct lending investments can offer substantially higher yields in this environment. Loans made directly to companies will usually offer coupons of 6-10%, significantly higher than comparable public debt. This pickup in yield is attractive for investors like pension funds, insurance companies, endowments, and family offices looking for bond alternatives.
Floating rate loans help insulate against rising rates
Unlike traditional bonds which carry fixed coupons, direct lending investments often utilize floating rate loans. The interest rates on these loans adjust periodically based on changes in benchmark rates. This helps insulate investors against rises in interest rates. If benchmark rates go up, the coupon rates on direct loans will also increase. Many fixed income investors favor floating rate loans currently as a way to mitigate exposure to rising rates.
Senior secured structures provide downside protection
Direct loans are structured as senior secured debt. This means they have priority claim on assets and cash flows, ahead of unsecured debt and equity. The loans are also typically backed by collateral such as real estate, inventory, receivables, or equipment. This security offers investors some downside protection in case the company runs into financial difficulties. The ability to actively monitor the collateral through the term of the loan is another advantage direct lenders have over buying syndicated loans on the secondary market.
Private equity sponsorship provides due diligence
Direct lending is frequently utilized by private equity firms who acquire companies through leveraged buyouts. The private equity sponsor will perform significant due diligence on the acquisition target before committing capital. They have strong financial incentives to understand the company’s business model, risks, and growth potential. Direct lending investors can benefit from this due diligence when determining credit quality. The ongoing involvement of the sponsor can also improve governance and alignment of interests.
Illiquidity poses a challenge
The loans made in direct lending investments are privately negotiated and not traded on public exchanges. This makes them difficult to sell before maturity. Investors need to account for the illiquidity and ensure they have an appropriate time horizon. Liquidity risk also tends to increase in market downturns when buyers disappear.
Lack of standardization creates complexity
Each direct loan is unique, with bespoke terms tailored to the specific company and situation. This lack of standardization creates complexity for investors looking to build diversified portfolios. Significant due diligence is required to analyze loan documents and collateral for each investment. There is also a lack of broadly available historical performance data.
Most managers have short track records
Direct lending only gained significant traction following the global financial crisis as banks pulled back from commercial lending. Most private debt fund managers have started within the last 5-10 years. This means investors have limited data with which to analyze and select managers. The relative lack of track record poses a diligence challenge.
In conclusion, direct lending investments allow investors to gain exposure to corporate credit in a way that offers higher yields, protection against rising rates, and potential downside protection through collateral and security structures. However, these benefits come with the costs of illiquidity, complexity, and managers with short track records. For investors willing to undertake the required diligence, direct lending can be an attractive option for portfolio diversification and yield.