With traditional banks more likely in recent years to lend to large corporations, small and mid-sized companies — major drivers of the U.S. economy — have been forced to look elsewhere for capital that will enable them to fulfill their growth potential. An increasingly popular option is direct lending.
Described by some as bank lending without the bank, direct lending’s rise can be traced to the aftermath of the 2008-09 recession, when Congress imposed stricter regulations on banks.
Banks in turn found upper-tier companies to be far more appealing lending options because of cash flow, collateral and debt-to-income considerations. Left out in the cold, middle-market companies turned to alternative and direct lending solutions to raise money and fuel their growth plans.
Unlike traditional banks, direct lenders are not regulated and do not have to conform to leveraged lending guidelines. As a result, these lenders can flexibly finance the more difficult or disaffected segments of the capital structure, including small and middle-market businesses.
Though the direct lending market has long been borrower-friendly, lenders have also found direct lending highly appealing. It’s one of the few options that provides strong, consistently high returns in the private debt market.
During an economic downturn, for example, a standard stock portfolio might lose 33 percent of its accrued value. But direct lending cuts out intermediary actors like banks, so returns are stronger and more predictable for investors.
According to Preqin data, roughly 50 percent of surveyed investors believe that direct lending presents the best opportunities in private credit. As of December 2018, direct lending assets under management totaled an all-time high of $266.4 billion: That’s more than one-fourth the amount of capital that comprises the entire private credit market.
But what is direct lending, exactly? What are the benefits to businesses and lenders? And which companies benefit most from direct lending solutions?
This article provides answers to those questions, and more. Let’s dive in.
What is Direct Lending?
As the name implies, direct lending is a credit provision that cuts out all middleman institutions, like investment banks, brokers, or private equity firms.
Most borrowers that seek direct loans are small to medium-sized businesses categorized as SMEs (Small and Medium Enterprises). Lenders are often wealthy individuals, asset management firms, business development companies or even peer-to-peer crowdfunding sources for very small companies.
As mentioned above, alternative-lending options became a better alternative for SMEs when traditional institutions were subject to stricter regulations after the ‘08-09 financial crisis. There are roughly 29 million businesses with 500 employees or fewer in the U.S., accounting for 99.7 percent of all the nation’s companies and nearly half of its employees, and those small and mid-sized businesses are in constant need of capital for growth.
Business development companies (BDCs) have been as adept as any private lender at supporting SMEs. BDCs grew out of two pieces of legislation, passed 40 years apart. First was the Investment Company Act of 1940, which in the wake of the Great Depression limited the number of people or companies who could invest.
That also reduced the amount of capital available to smaller businesses, but the Small Business Incentive Act of 1980 corrected that by allowing for the creation of BDCs. (And unlike traditional financial institutions, a wide range of investors can invest with BDCs, not just the wealthiest.)
Direct lending, whether by BDCs or other lenders, meets companies where they are, providing dynamic funding options for businesses that have limited credit history or considerable debt. Not only does direct lending fill a gap in the market, it provides lenders and borrowers with opportunities that might otherwise be economically unfeasible.
How do these loans work? Asset managers raise capital from a variety of investment sources before making a leveraged loan offer directly to the potential borrower. As one of the most flexible categories of debt financing, direct lending can be contracted in three ways:
- First lien: The borrower must pay off the loan before all other classes of debt.
- Second lien: That debt that must be paid off after a senior lien.
- Unitranche debt: Any hybrid loan structure that combines both junior and senior debt into one blended interest rate of repayment. Unitranche structuring increases the flexibility of direct lending options, providing companies increased access to capital.
The flexibility offered by alternative lenders is one of the things lendees find most appealing. BDCs and similar institutions can take on more risk than traditional lenders. They can also develop stronger, deeper relationships with the company, the result being that everybody wins: The company realizes its growth potential, and investors see higher yields.
As an example of the latter, consider the Arizona Retirement System, which recently increased its direct funding allocation to 17 percent of the $41 billion pension fund. Arizona’s senior portfolio manager said that the allocation “attempts to replicate what we could do in the public markets but in the private world … with superior due diligence, superior covenants, and superior returns.”
What Companies Benefit Most From These Loans?
Direct lending represents a continually increasing share of the American corporate loan market. Before the financial crash, direct lending sources primarily served small companies with an EBITDA of less than $50 million.
Over time, the funding option has grown to comfortably accommodate large-market figures and publicly traded companies. In 2017, direct lenders once again topped historic figures by committing financing packages as large of $1.45 billion to borrowers.
It should be no shock as to why the unitranche deal size record has been continuously broken: Direct lenders are largely unregulated in contrast with traditional institutions, allowing them to provide highly flexible loans without strictly adhering to leveraged loan guidelines.
“Several years [ago], it seems like a couple hundred million for a private credit manager was a large deal — then it was $500 million,” Ryan Lynch, one KBW analyst, commented. “The limitation gets higher (every year).”
Though larger businesses are rushing into the market, small and mid-sized businesses remain the most prominent type of borrower. The flexibility offered by alternative lenders is a big reason for that. Middle market companies get access to multi-layered funding that makes it possible for them to realize their growth potential.
Direct lenders still favor the middle market, too, since it is one of the largest investment pools they can draw upon. In the United States, over 200,000 businesses fall into that category, comprising a third of the American economy. The middle market creates two out of every three new jobs in America, and employs over 50 million people.
The middle market can actually be broken down even further into the lower, middle and upper middle market.
Lower market companies are those with an EBITDA of $15 million or less, seeking loans between $5 million and $25 million. The squarely middle market companies have an EBITDA between $15 million and $40 million (seeking loans under $100 million), while upper middle market companies feature an EBITDA over $40 million and net loans over $100 million.
Direct lending has had a tremendous impact on the middle market in recent years. In 2019, private equity activity in the mid-market sector of the economy surpassed $500 million for the first time ever. Equally telling is the fact that unitranche lending rose to 23 percent of the total US sponsorship of the middle-market (up from the 14 percent just two years prior).
The Advantages of Direct Lending
The growth of direct lending has enabled mid-sized businesses and lenders to prosper from favorable terms, greater term flexibility, high yields and negotiable risk.
Middle market businesses are far more likely to secure a sizable loan from a direct lender than from a traditional financing institution. While banks are scared off by the risk of providing loans to small businesses, direct lenders aren’t beholden to strict institution-wide financing regulations.
Not only are direct loans less difficult to secure, the terms are, by comparison, much more favorable for middle market companies. Banks secure loans with high-interest rates and fees to mitigate risk while direct lenders are more capable of working personally with the borrower during negotiation and throughout the term of the investment.
While businesses have found bank loans harder and harder to procure, direct loans enable them to acquire working capital that will allow them to immediately finance their growth activities. This is especially important for businesses that struggle early on due to a lack of immediately available cash.
Since the business works directly with the lender, both parties can work on a creative loan arrangement that fits their needs. It’s rare for direct lenders to saddle small businesses with large down payments, for example, even if the particular company has limited credit history.
In short, direct lenders boast the flexibility that banks are unable to offer. Borrowers get access to favorable loan terms and, in some cases, the guidance to effectively navigate a growth phase.
At the same time, direct lending has proved very beneficial for lenders and other financiers as well: it’s one of the few fields that provides investors the ability to net high-yield, consistent returns.
Of course, all financial investments carry inherent risk. By its very nature, direct lending runs unregulated and isn’t backed by the same guarantees provided by traditional bank lending. Some analysts feel growing concern over the rapid growth of the immediate capital lending environment, stating that the market has gotten “too hot.”
Like all loans, success is entirely reliant on good strategy and great execution. Lenders need to undergo a significant underwriting process to ensure that loans are only granted to borrowers with a high probability of success.
According to Preqin, the average annual yield from direct lending funds rose 13 percent from 2013 to 2018. Even the highest-yield corporate bonds trail at just 7 percent returns, while the US 10-year treasury yielded only 1.71 percent as of 2019 (which has sunk below 1 percent during the COVID pandemic).
To drive the point home even further, compare direct lending’s 13 percent growth to the S&P’s average annual return of 9.8 percent over the past nine decades — a yield that comes with significant losses during periods of recession.
The Verdict: How Will Direct Lending Adapt to Challenges?
Over the past decade, direct lending has become one of the most attractive segments of the alternative funding market. Investors are increasingly realizing that it’s more than possible to achieve high yield with low risk and favorable liquidity.
Put simply, direct lending is now a primary component of well-diversified investment portfolios. According to the Bank of America, the US private debt market has more than doubled in the past decade. The Alternative Credit Council (ACC) has predicted that worldwide direct lending will overtake the $1 trillion mark this year.
Once a relatively minor player, direct lending accounts for more than half of all private debt fundraising. Average fund sizes have grown enormously, with direct lenders amassing $185.7 billion since 2017.
How do we account for this surge to the top? There are three primary reasons: the steady retreat of commercial banks from lending to SMEs, increasing demand for capital among mid-market companies, and investors’ strong desire for fixed income with high yield.
Of course, it would be remiss to not mention the recent impact of the COVID-19 pandemic. Preliminary data demonstrates that the pandemic is disproportionately affecting the middle market, with smaller companies experiencing depressed revenue and an inability to adjust.
It’s likely that the COVID market effect will have lasting ramifications: 51 percent of company survey respondents expect a steady decline that progresses well into late 2020.
Still, there are plenty of reasons to be optimistic. Over 80 percent of mid-market businesses believe the situation will normalize after six months, at which point direct lending solutions will enable them to gain access to capital to realize their growth potential.
Direct lending was, is, and will continue to be one of the most popular forms of financing for small and medium-sized businesses.