By: CAIS, the leading alternative investment platform
Stepping into the void.
As investors seek income in today’s persistently low interest rate environment, at CAIS we have witnessed direct lending strategies become increasingly popular as an income alternative. Stepping into the void left by banks after the 2008 financial crisis, non-bank lenders providing direct lending have grown almost four-fold to over $812 billion1. In addition to their higher yield, the floating rate structure helps offset the risk to capital should interest rates increase2. The recent market dislocations have reduced liquidity and strengthened the position of lenders based on our discussions with asset managers, indicating that direct lending will continue to grow in its popularity as an income alternative. In this piece, we take a look at the features of direct lending.
Direct lending is a subset of private debt where loans are directly negotiated between the lender (asset managers, and insurance and specialty finance companies) and middle market companies. In bypassing the usual intermediaries such as banks and brokers, the loan terms can be much more flexible and customized to address unique financing needs.
Middle market companies are broadly defined as those with annual earnings of between $10 and $100 million and are typically sub-investment grade borrowers. The universe of middle market companies can be further broken down by lower-middle market, middle market and upper-middle market. These middle market companies are similar in size to those found in the Russell 2000 Index3. By virtue of their sub-investment grade classification, these borrowers may have a higher the risk associated with lending to them. Where risk is assessed to be greater, lenders will generally seek to build various protections into the loan agreement, commonly referred to as covenants. These covenants can restrict or require certain actions if specified financial conditions are met and provide security to the lender.
The loans themselves are also generally assigned various degrees of seniority, which determines the order of claims on a company should it go into default. Senior, or first-lien debt has first claim on asset, while subordinated, or second lien follows. To accommodate the borrowers’ desire for a single source of financing, unitranche loans that combine both senior and subordinated loans into one have become more common4.
In bypassing the usual intermediaries such as banks and brokers, direct lending loan terms can be much more flexible and customized to address unique financing needs.
From a Borrowers’ to a Lenders’ Market
Since the 2008 financial crisis, borrowers have had ready access to capital at favorable terms as a direct result of the monetary policies enacted by global central banks. This placed borrowers in a strong negotiating position given the many source of funds they had access to from non-bank lenders. As liquidity has dried up and global growth has slowed, the market has shifted to favor lenders who can now command stricter covenants and better loan-to-value ratios according to asset managers we have spoken to. This is especially true for those who lend to lower-middle market borrowers, according to fund managers we have been speaking with.
Direct Lending Today
Unlike bank and high-yield debt, direct lending loans typically have a floating interest rate. A direct loan rate is set relative to a short-term base rate, with an additional spread to reflect the risk of default and illiquidity. This contrasts with bank loans that have periodic resets, as well as bond mutual funds that primarily hold fixed-rate securities5. Direct loans also typically have less interest rate sensitivity than bank loans and mutual funds. As price moves inversely to interest rates, this essentially means that their price is less sensitive to increases in interest rates. With interest rates currently sitting at historical lows, the upside potential appears to favor direct lenders both from the perspective of additional yield and less price sensitivity to changes in rates, though there is no telling when rates will rise.
The Potential Role of Direct Lending
As potential income alternative to non-investment grade fixed income, or a lower-risk alternative to private equity, direct lending has shown through historical data and relationships outlined below, to provide potentially attractive characteristics relative to traditional and alternative asset classes alike.
Looking at asset class return and risk data from September 2004 to December 2017, we find the below relationships.
- Income Alternative to Non-Investment Grade Fixed Income: While positively correlated at +0.7, the maximum drawdown of direct lending over this period was -8% verses high-yield bonds at -27%6. Additionally, the risk of direct lending was 3.5% versus high-yield bonds at 10.7%. As at May 31, 2020, the yield on direct lending was 9.5% versus high yield bonds at 9.4%7. These characteristics have the potential to make direct lending an attractive income alternative to high-yield bonds.
- Lower-Risk Alternative to Private Equity: Exhibiting the highest correlation to private equity of +0.8, the maximum drawdown of direct lending over this period was -8% verses private equity at -24%. Additionally, the risk of direct lending was 3.5% versus private equity at 9.2%.The return to direct lending over this period was 9.7% versus private equity at 14.1%. Given the higher correlation, but the potential return versus risk, direct lending has the potential to be a lower risk alternative to private equity8.
Into the Future
Initially taking advantage of the void left by banks after the last financial crisis, the investment characteristics explain why the strategy has become popular with investors. Given the low interest rate environment, as well as the fact that it has become a lenders’ market, it can be expected that direct lending will continue to be sought by investors as an income alternative to non-investment grade fixed income, or as a lower-risk alternative to private equity.
1. Bloomberg, “Why Direct Lending is a Booming Part of Private Debt”, https://www.bloomberg.com/news/articles/2019-03-06/who-needs-a-bank-why-direct-lending-is-surging-quicktake-q-a, Accessed 5/25/2020. 2. Stephen L. Nesbitt, “The Investment Opportunity in U.S. Middle Market Direct Lending”, The Journal of Alternative Investments, Summer 2017. 3. Stephen L. Nesbitt, “Private Debt. Opportunities in Corporate Direct Lending”, 2019. 4. Mercer & CAIS, “Fundamentals of Private Credit Whitepaper”, 2019. 5. Stephen L. Nesbitt, “Private Debt. Opportunities in Corporate Direct Lending”, 2019. 6. Stephen L. Nesbitt, “Private Debt. Opportunities in Corporate Direct Lending”, 2019. 7. J.P.Morgan, Guide to Alternatives, 2Q 2020. 8. Indices – Direct Lending: Cliffwater Direct Lending Index, Private Equity: CA US Private Equity Index, High-Yield Bonds: Bloomberg Barclays High-Yield Index.