Alternative Investments 2.0 - Группа авторов

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2.2 Corporate Direct Lending (Core Strategy)

      Numerous trends have driven the growth of the direct lending market in the US and Europe:

       Bank constraints: After the GFC, banks were subject to regulatory reforms that required them to hold greater levels of capital reserves. Subsequently, banks had to deleverage their balance sheets and deploy their capital more deliberately. The general trend for banks was to focus on large corporate and investment-grade lending, creating a vacuum in financing for middle-market companies.

      Exhibit 2: Number of Global Private Debt Deals; Banks vs. Private Debt Firms

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      Source: Preqin, as of July 2020

       Private equity: Private equity sponsors, particularly in the middle market, have increasingly used debt funds to finance their investments due to the speed of execution and the flexibility of financing solutions that direct lenders can offer relative to banks. During the GFC, when it would have been needed the most, private equity sponsors lost support from banks as underperforming loans were passed to recovery units. Private equity firms were forced to bear significant losses, which harmed their relationships with banks and accelerated the growth of direct lending.

       Borrower education: As the direct lending solution developed, the transaction ecosystem supported its growth through education of borrowers. Management teams of corporations typically have more conservative attitudes with entrenched preferences for borrowing from banks. To win them over, debt advisers, lawyers, and accountants have presented the advantages and risks of direct lending compared with traditional bank financing structures. Gradually, CEOs and CFOs have come to understand the benefits of working with both debt funds and banks to grow their businesses.

       Investor appetite: Debt funds’ clear and coherent investment thesis for direct lending has resonated with investors. Direct lenders have been able to raise significant amounts of capital, which in turn supports their ability to compete against banks, further driving the asset class’s growth. As the fund sizes increase, direct lenders have improved their ability to vie for larger transactions as an alternative solution to capital markets.

      To understand direct lending’s performance profile, it is important to analyse the returns through a cycle. Exhibit 3 underlines the resilience of direct lending as it has maintained at least a 7.2% loss-adjusted return over the last 14 years.

      Exhibit 3: US first-lien[5] Corporate Direct Lending gross and loss-adjusted yields through the cycle (by vintage)

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      Source: StepStone Private Debt Internal Database, based on 5,600 US first-lien loans

      To better understand the market dynamics behind the growth of corporate direct lending, it is important to highlight the advantages for borrowers. These characteristics sustain the continuing uptake of direct lending by middle-market companies:

       Control: Direct lenders will maintain close relationships with sponsors and management teams of borrowers after originating the transaction. Even if the loan experiences difficulties and defaults, a direct lender will continue to work closely with the borrower for a resolution. This stands in stark contrast to how banks operate. When a loan underperforms, banks send it to an internal workout team, which aims to remove the troubled asset from the bank’s loan portfolio, and not to help the borrower restructuring the business.

       Speed of execution: The private equity landscape is increasingly competitive, and many sponsors are pre-empting sales processes to gain an advantage over other bidders. Therefore, sponsors are seeking direct lenders that can move quickly alongside them in submitting binding offers for investment targets. As direct lenders have smaller teams and more flexible investment approval processes than banks, they can offer the speed of execution that sponsors need in competitive sales processes.

       Structural flexibility: Direct lenders have less rigid policies in place compared with banks and can provide more flexibility in structuring customised financing solutions. For example, direct lenders have shown flexibility in capital repayment, typically structuring a “bullet” profile so that 100% of principal is repaid at maturity. This allows the borrower to use its free cash flow to grow the business as opposed to repaying principal. Direct lenders also exhibit more flexibility than banks in the negotiation of key terms in loan agreements. Greater flexibility can also be provided during the life of the loan would the issuer face an adverse situation as demonstrated during the COVID-19 crisis. For instance, direct lenders quickly agreed to suspend or postpone interest payments for companies confronted with liquidity issues.

       Business partners: In the case of non-sponsor transactions (i.e., with no private equity firm involved), direct lenders can provide support to management teams in addition to debt capital. Like private equity firms, direct lenders can give management teams access to their relationship networks to access more customers, sector expertise, more supplier relationships and operational experts supporting the companies’ financial and operational performance.

      When assessing direct lending strategies, investors should not neglect the investment risks particularly toward the end of an economic cycle.

      During the last 10 years, valuation multiples gradually increased with the expansion of the economic cycle. In turn, sponsors steadily pushed leverage levels up in line with pre-GFC peaks to compete in sales processes and meet valuation expectations. Even though leverage levels were steadily increasing in line with valuation multiples, sponsors increased their equity cheque at a faster rate over the period. Hence, the cash equity cushion below the debt in the capital structure typically remained in excess of 45%, in line with post-GFC figures.

      Key terms such as “covenant headroom” and “EBITDA adjustments” are gaining importance in borrower-friendly environments. The importance of data as well as deeper analysis of direct lenders’ term sheets and financing structures is critical to understanding the genuine risk profile investors are taking. Covenant headroom can be compared to a margin for error granted to borrowers when defining the covenant level. It is formally the relative difference between the level of a financial metric at origination and the agreed covenant level.

      In most cases, covenant headroom decreases over time, as covenants tend to be stricter over the life of the loan. EBITDA adjustments, or the practice of taking credit for cost savings and other pro forma adjustments, became popular in the past few years. By overestimating a company’s profitability, these adjustments skew the valuation calculus, making companies seem less expensive than they really are. In turn, it becomes much easier for a sponsor to lever up the company. While private equity sponsors have become more creative in how they define EBITDA, direct lending GPs (and co-investors) must rely on a quality of earnings report. Published by reputable accounting firms, these reports help the sponsor and lender determine which adjustments should be added back to EBITDA and which

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