Written by: Susan Kasser | Neuberger Berman
Given today’s market environment, we think investors may want to look at what Direct Lending can provide.
The sudden rise in interest rates since mid-2022, together with the denominator effect, has forced allocators to rethink their private market exposure.
This is unfortunate because today’s environment affects the various private markets very differently—and not necessarily unfavorably. However, we would argue that Direct Lending strategies in particular currently benefit from three significant tailwinds and two distinct advantages:
- Because the private equity industry has significant dry powder to deploy, dealmaking has continued albeit at a lower rate. Those transactions still need funding, which could lead to a healthy pipeline of opportunities for direct lenders.
- Banks (nursing sizeable losses from their balance sheets) appear to have all but abandoned the syndicated finance market. This absence of competition is enabling direct lenders not only to be more selective, but to also negotiate higher lending spreads and better covenant terms.
- Higher rates benefit direct lenders directly as most direct debt is structured with floating rates. By contrast, higher rates put pressure on private equity sponsors to narrow their focus on companies with lower leverage and significant value catalysts, in order to offset higher borrowing costs. This higher rate environment is expected to last well into 2023, if not longer.
- Higher rates may be good news for lenders, but they can be bad news for borrowers—they raise the risk of default, especially during an economic slowdown. But this is where a direct lender’s position, as often the most senior provider of finance in a borrower’s capital structure, can be an advantage. Direct lenders typically underwrite First Lien or Unitranche loans ahead of private equity, but also ahead of most public bond investors. Moreover, the companies they lend to are typically owned by a small number of experienced, private owners who can draw on deep expertise across multiple economic cycles; and can inject equity quickly at times of duress.
- With IPO markets closed and strategic buyers mostly inactive, private equity sponsors are getting forced to extend ownership of their assets until exit opportunities reopen. Even if they eventually realize their target multiples, longer holding periods mean internal rates of return (IRRs) for private equity funds could tail off. But we think for direct lenders, longer holding periods simply mean more coupons to compound, increasing multiples and leaving IRRs unchanged.
Add these factors together and we believe current conditions offer a compelling opportunity for a subset of direct lenders.