Direct lenders’ golden moment is over

Smartsheet

11/10/2024 13:00

(The author is a Reuters Breakingviews columnist.  The opinions
expressed are his own.)
    By Jonathan Guilford and Neil Unmack
       NEW YORK, Oct 10 (Reuters Breakingviews) - The downside
of having a “golden moment” is that things can only get worse.
That’s what direct lenders, or the core of the private-credit
world that focuses on buyout debt, are finding little more than
a year after Blackstone  BX.N  President Jon Gray pronounced a
heyday for non-bank credit providers writ large. The forces that
boosted direct lending to roughly $850 billion in assets under
management by the end of 2023, using Preqin figures, are waning.
It spells lower returns and partnerships with banking frenemies.
    In the pandemic’s wake, specialists like Blue Owl Capital
 OWL.N , Ares Management  ARES.N  and diversified giants like
Blackstone and Apollo Global Management  APO.N  took a bite out
of the traditionally bank-dominated leveraged finance business.
Direct lenders’ share of loans to highly indebted companies,
including those owned by private equity, grew from 7% in 2018 to
17% by mid-2023, according to JPMorgan.
    The size of the median loan rose nearly five-fold between
2014 and 2021, the American Investment Council reckons, as the
industry’s largest funds jumped on beefy leveraged buyouts like
Hellman & Friedman and Permira’s $10 billion acquisition of
Zendesk. And because direct lenders typically use floating
rates, yields surged as central banks hiked. The net return on
Ares’s Senior Direct Lending Fund II rose from 10% at the end of
2022 to 15% a year later, roughly the level typically targeted
by private equity funds.
    But the heyday had as much to do with competitors’ weakness
as direct lenders’ strength. In 2022, Wall Street players like
JPMorgan  JPM.N , Bank of America  BAC.N  and Barclays  BARC.L 
got stuck holding $80 billion of mostly buyout debt. That
predicament, a product of fast-rising rates, ran counter to the
banks’ favored model of quickly selling loans to investors. It
clogged up Wall Street balance sheets, giving private players
free rein. As a result, about three-fifths of buyouts in 2023
relied on direct lenders, according to consultancy McKinsey.
    Now, however, loan and bond markets have recovered thanks to
central-bank rate cuts and the absence of a recession.
Deal-starved credit investors, like collateralized loan
obligations, are hungry again. Public loan markets financed a
larger share of buyouts by volume than private credit funds did
in the three months to September, reckons PitchBook LCD. Renewed
competition from banks means direct lenders are having to offer
lower rates. For private loans to large borrowers, the spread
over benchmark rates fell from 6.4 percentage points in early
2023 to 5.2 percentage points this July, according to ratings
firm KBRA.
    Direct lenders aren’t just losing out on new deals.
Borrowers who had turned to private markets during the golden
era can now refinance at a lower cost in public markets, and so
are able to play the two markets off against each other. Some
$22 billion of these refinancings happened this year in the U.S.
alone, PitchBook LCD data shows. Examples in Europe include
French insurance broker April, which issued a public loan at a
spread that was 2.5 percentage points lower than the private
borrowing it replaced. To hold onto business, direct lenders are
having to accept lower rates. Italian pharmaceutical group Doc
Generici managed to slash the coupon on a recent refinancing
deal with HPS and Blackstone, after banks tried to lure it away.
    Admittedly, direct lenders have some advantages that will
endure, including greater speed, certainty and goodies like
so-called delayed-draw loans, which borrowers can use to fund
future acquisitions. The non-banks also provide more leverage
than regulation-constrained Wall Street players – typically up
to a turn of EBITDA.
    Finally, direct lenders can back companies with minimal free
cash flow by measuring debt against recurring, sticky revenue.
That gives them the run of deals involving fast-growing software
groups, like the Blue Owl-led package for Smartsheet’s  SMAR.N 
recent buyout. Meanwhile, those who have stayed focused on
smaller borrowers too little to avail themselves of a syndicated
alternative, like Bain Capital's lending arm, are still seeing
the highest spreads.
    Direct lenders and banks can work together. Take the
possible $17 billion buyout of Sanofi’s  SASY.PA  consumer
division. If it happens, that deal may rely on banks offering
senior debt and private lenders providing riskier junior loans,
together bringing leverage to around 7 times EBITDA, according
to a person familiar with the matter. Pricing subordinated debt
is hard, and there’s limited appetite for it in public markets,
giving private credit an edge.
    Yet even here, competition is tough. Direct lenders must
deploy their bulging pools of capital, meaning they're having to
compete for the same relatively risky deals. The extra return
over interbank rates available on low-ranking private debt has
come down to around 7 percent recently, according to one banker.
That implies returns can still exceed 10% or so, but only by
taking more risk.
    The bigger private credit shops are best placed to cope with
adversity. Some can tap more liquid sources of funding, giving
them access to cheaper capital. Blackstone has brewed up a
private credit CLO, for example, while other players have their
own listed lending arms, like Ares Capital  ARCC.O , allowing
them to issue relatively cheap bonds. Ares has also gotten more
involved in the syndication process, as evidenced by its role
helping to dole out part of a public-private loan package for
Bain's $4.5 billion take-private of Envestnet  ENV.N .
    Another avenue is to partner more explicitly with banks.
Apollo recently struck a $25 billion partnership with Citigroup
 C.N , covering direct lending and private credit more broadly,
which should give Marc Rowan’s asset manager a continued flow of
future buyout deals to finance. It’s generally easier for the
bigger direct lenders to seal these kinds of cooperation
agreements, since they have the funds to make it worth banks’
while.
    The giants of private credit also arguably have bigger fish
to fry. Apollo is feeding the balance sheets of insurers and
annuity providers, including one that it owns, with credit
sourced from new realms like asset-based finance. Rowan reckons
that opportunity will easily eclipse the size of the traditional
direct lending market. KKR  KKR.N , Blackstone and others have
different versions of the same basic idea. Other large players,
like Ares, also manage public loan funds, meaning they should
benefit even if deals keep moving away from the private market.
    That means the smaller players will feel the worst of the
pain in the new, leaner years. The minnows are already
struggling: the top 10 private debt funds took over half of all
new capital raised in 2023, according to Preqin. Those outside
the top 50 saw their share collapse to 9% from 24% the year
before.
    Still, the big beasts can’t escape the reality of lower
yields. Even as they’ve diversified elsewhere, the largest
players are still sitting on vast amounts of money dedicated to
direct lending. Investors have poured $138 billion into private
credit overall this year, Preqin says, outstripping pre-golden
era years like 2019 and 2018. With public markets roaring again,
anyone hoping for a repeat of the recent stellar returns will be
disappointed.
    
    Follow @JMAGuilford on X
    

    <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Direct lending returns are outpacing buyouts    https://reut.rs/4eTQisS
Private loan spreads are coming back down    https://reut.rs/4eYUibM
    ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
 (Editing by Liam Proud and Pranav Kiran)
 ((For previous columns by the author, Reuters customers can
click on  GUILFORD/  
Jonathan.Guilford@thomsonreuters.com
neil.unmack@thomsonreuters.com))