Discussing the evolution in private credit and the rapid growth of direct lending in recent years. How did we get here, and where are we headed?
Ioana Barza: Welcome to the Lending Lowdown. I’m Ioana Barza, Head of Market Analysis. I’m joined by CJ Doherty, Director of Market Analysis. We’re excited to host our third podcast. Our focus this episode is on private credit, which has drastically altered the lending landscape.
CJ Doherty: You’re not kidding Ioana. Private credit is very popular these days. In this episode we want to give you the lowdown: what it is, and why it’s revolutionizing the lending space.
IB: That’s a tall order CJ. Private credit, referring to debt largely held by non-bank lenders, changed the breadth and depth of capital providers, and brought in a lot of new investors from various pockets across asset classes.
CJ: Right Ioana and it’s a market that’s roughly $1.3 trillion in size and its growing! That makes it roughly the same size as the CLO market, that’s Collateralized Loan Obligations, who are the biggest buyers of syndicated leveraged loans. To quantify it a bit more, one of the more transparent vehicles in the private credit or direct lending space in the US is Business Development Companies or BDCs as we call them, and these particular funds have over $250bn of assets and growth in the BDC market has surged recently, with assets under management nearly doubling in size in the last two and a half years. Just to add some more stats, there are over 300 direct lenders and notably the top 50 or so platforms in the space control over half of AUM.
IB: It’s kind of hard to wrap my head around that and its hard to believe just how quickly this all came about. So in the early 2000s, bankers with long track records of lending to smaller companies started their own shops. They provided much needed support via financings during that economic downturn and it paid off. Many of their portfolio companies not only performed well but they grew rapidly in that recovery and of course this supported the track record of these new non-bank lenders. And back then we actually called them specialty finance lenders.
CJ: Right and when the Great Financial Crisis took its toll on the banks and as we know new regulations came out to prevent it happening again, there was Volcker, etc, but specifically I’m referring to Leveraged Lending Guidance.. which placed some restrictions on banks’ lending activity, and this in turn created opportunity for non-banks to step in as they were unregulated and not subject to the same rules
IB: As those opportunities grew, so did their funding sources. So initially back in the early 2000s, these specialty finance companies they were reliant on pretty limited sources of funding, that’s how they got started, like just issuing a balance sheet CLO. So I remember going on tours and speaking to sold out rooms of investors in London, in Dublin and New York and explaining how these vehicles worked, and what were these middle market loans they were investing in and needless to say they gained traction very quickly.
CJ: Yes they sure did and after the Great Financial Crisis, these shops attracted more capital from investors like insurance companies, pension funds and sovereign wealth funds; They also formed strategic partnerships, alliances, sidecars, joint ventures, in essence diversifying their funding platforms
IB: It was quite a steep learning curve for investors and then of course private equity also got in the game. So, they leveraged off of their fundraising capabilities, they set up their own direct lending funds, and this is alongside the capital markets groups they had also set up. We essentially saw the institutionalization of private credit.
CJ: Yes we sure did and as the investor base diversified, so did capital structures, further attracting investors interested in higher yields to get in the game. If we look back to the early 2000s, these lenders began offering a one stop shop for the first time, as it was called back then, so you could get your junior/senior execution, get access to more junior debt like second liens. So effectively, borrowers started to get a whole menu to pick from.
IB: And this menu it ranged from mezzanine, so there were funds devoted solely to mezzanine; senior stretch, first lien/second lien. This menu got bigger and bigger for these smaller middle market issuers, but then it started to expand and they started to serve larger issuers, offering now some of the biggest deals we see in the market.
CJ: Yes and look at the rise of the jumbo unitranches. Unitranches were the evolution of the one stop shop, giving issuers the whole capital stack in one loan and they have grown dramatically in size.
In fact, in 2019 we saw 3 deals over $1bn in size. More recently we saw 19 unitranches in the first half of this year alone which were over $1 billion.
IB: It was such a big deal when we saw the first uni over $1 billion. You know everybody sort of scratched their heads, you know how much growth are we going to see here? What enabled this growth? And that really goes back to the fundraising efforts because that led to a diversification in the investor base. And if you think about it, when you manage a growing array of institutional accounts, now that allows you distribute risk, it allows you to take on bigger commitments. So hold sizes for these deals climbed dramatically and they really do still remain a differentiating factor.
CJ: Even this year you know which has been marked by volatility in the credit and equity markets, we still tracked a hefty $90bn in private credit fundraising and this was targeting the middle market in the first half of the year. So a lot of money.
IB: This provideds borrowers with so much more optionality. So again, going back to the start in 2000, when these one-stop shops emerged and they offered you the financing you desperately needed in an uncertain time but actually it really also quickly became a mainstay throughout the cycles, albeit, at a premium. And that premium for a borrower it offered you certainty and speed of execution; limited or maybe no price flex, higher leverage, more flexibility in your capital structure, that menu we talked about, and no ratings process.
CJ: This premium also meant a higher yield for investors, which proved to be particularly attractive in the low interest rate environment that we’ve seen most of the time since the credit crisis. Yields on loans have been enticing relative to other asset classes, and its attracted investor money and as we have noted, we have seen a huge amount of money flow into the asset class. Moreover, given appetite for higher yield, direct lending funds are often structured to lend further down the cap stack than banks. For example, they have been doing you know second-liens even if the broadly syndicated lenders were doing the other portion. And of course, it does vary between and across different types of private debt fund. Looking at BDCs again just as an example, they have shifted in recent years to a larger share of first liens.
IB: You know you have got to keep an eye on this space because it is so dynamic. These shifts are constantly happening and it’s also really competitive as you can see. Its attractive to investors, attractive to lenders but direct lender fees and fund fees have been under pressure because of that because it is a really competitive environment. We have also seen funding sources continue to shift, so they have been broadening across geographies. And also here in the US, now the retail and wealth management channels have been tapped. Now CJ, BDCs always had retail element.
CJ: Yes, they certainly have Ioana. And you know what’s really interesting when it comes to tapping retail investors, is that in the last 18 months we have seen the introduction of perpetual-life BDCs. And these funds are structured a little differently. They continually offer new shares monthly but they also offer to redeem 5% of shares every quarter so they offer investors some liquidity. So, I would say more liquidity than the average private debt fund but not as liquid as a public BDC. And they have grown a lot. In aggregate they have $74bn, $75bn in AUM as of June, and impressively that’s up from only $12bn a year earlier, so it shows tremendous appetite from retail investors including the high net-worth variety.
IB: You know CJ you touched on liquidity and that something, it’s something to really think about. These investors do have to think about these rather less liquid assets. And I also want to say and maybe it goes without saying, that direct lenders have also had challenges as has every asset class, with Covid, with volatility we have been through recently, deals stalled and there was a lot of caution on lenders’ part. Now lenders kept the doors open and that’s kind of what we anticipated and what we saw and we have come through some of that, but not without difficulties and if we look ahead we are facing a lot of uncertainty. So how will portfolio companies perform? We are in an inflationary environment, there is a lot of headwinds, supply chain, labor issues, it is not clear sailing ahead for these issuers. And, what is also fascinating to me about this is the way banks have navigated and participated in this space. But I think that is for another day.
CJ: In these last 10 minutes we have tried to touch on something that’s been evolving for over 20 years. We have barely scratched the surface. So for more on this topic, check out our reports and analysis at loanconnector.com.
IB: And join us in person this year at our annual conference, which is being held November 2 in New York. Thank you for listening and please subscribe to the Lending Lowdown on Spotify or your favorite podcast platform.