syndicate) to share the risk. Since the Global Financial Crisis (GFC), the number of commercial banks in the United States has fallen by more than a third, from 7,200 to less than 4,450.[1] Congress passed major reforms that limited the amount of risky assets banks could have on their balance sheets. The combined effect of fewer commercial lenders and more stringent capital requirements left a significant void in global capital markets. The middle market, consisting of companies with EBITDA below USD 75 million, was particularly affected, as banks turned their attention upmarket. Institutional lenders, in search of attractive yields, filled the gap left by banks. Lower capital supply as well as higher demand from investors and more flexible terms for issuers explain the growth of private middle market direct lending since the GFC.
Over the last decade, corporate private debt in the middle market – also referred to as direct lending – has matured into an institutional-quality asset class. In 2018, 182 private debt funds raised USD 119 billion. Not only have more funds been raised but deal sizes and volumes have also grown markedly. Private debt managers put more than USD 145 billion of capital to work across 1,345 transactions in 2019.[2] However, these numbers are probably understated; we estimate the overall middle market in the United States to be USD 1.25 trillion. With an average loan life between three and four years, this results in annual issuance of more than USD 350 billion. The European market is approximately a third of the US market, totaling around USD 410 billion.[3]
Private debt covers a large and diverse universe of strategies in the three main asset classes: corporate, real estate, and infrastructure. This universe has broadened to encompass the burgeoning field of specialty finance. Exhibit 1 serves as an extract of some of the main private debt strategies, comparing gross asset yield levels with public credit on a risk-adjusted basis. On that basis, the attractiveness of direct lending becomes obvious.
Exhibit 1: Indicative gross and loss-adjusted returns across various credit asset classes
Source: Bloomberg Barclays Indices, Credit Suisse, Thomson Reuters Quarterly MM Private Deal Analysis, StepStone Calculation as of June 2020
2.2.1 Overview
Corporate direct lending is the core strategy within private debt. It is responsible for most of the asset class’s growth over the last decade. Private debt AuM has grown globally, likely surpassing the USD 1 trillion mark several years ago.[4]
Numerous trends have driven the growth of the direct lending market in the US and Europe:
Bank constraints: After the GFC, banks were subject to regulatory reforms that required them to hold greater levels of capital reserves. Subsequently, banks had to deleverage their balance sheets and deploy their capital more deliberately. The general trend for banks was to focus on large corporate and investment-grade lending, creating a vacuum in financing for middle-market companies.
Exhibit 2: Number of Global Private Debt Deals; Banks vs. Private Debt Firms
Source: Preqin, as of July 2020
Private equity: Private equity sponsors, particularly in the middle market, have increasingly used debt funds to finance their investments due to the speed of execution and the flexibility of financing solutions that direct lenders can offer relative to banks. During the GFC, when it would have been needed the most, private equity sponsors lost support from banks as underperforming loans were passed to recovery units. Private equity firms were forced to bear significant losses, which harmed their relationships with banks and accelerated the growth of direct lending.
Borrower education: As the direct lending solution developed, the transaction ecosystem supported its growth through education of borrowers. Management teams of corporations typically have more conservative attitudes with entrenched preferences for borrowing from banks. To win them over, debt advisers, lawyers, and accountants have presented the advantages and risks of direct lending compared with traditional bank financing structures. Gradually, CEOs and CFOs have come to understand the benefits of working with both debt funds and banks to grow their businesses.
Investor appetite: Debt funds’ clear and coherent investment thesis for direct lending has resonated with investors. Direct lenders have been able to raise significant amounts of capital, which in turn supports their ability to compete against banks, further driving the asset class’s growth. As the fund sizes increase, direct lenders have improved their ability to vie for larger transactions as an alternative solution to capital markets.
2.2.2 Risk-adjusted Returns
To understand direct lending’s performance profile, it is important to analyse the returns through a cycle. Exhibit 3 underlines the resilience of direct lending as it has maintained at least a 7.2% loss-adjusted return over the last 14 years.
Exhibit 3: US first-lien[5] Corporate Direct Lending gross and loss-adjusted yields through the cycle (by vintage)
Source: StepStone Private Debt Internal Database, based on 5,600 US first-lien loans
2.2.3 Key Advantages for Borrowers
To better understand the market dynamics behind the growth of corporate direct lending, it is important to highlight the advantages for borrowers. These characteristics sustain the continuing uptake of direct lending by middle-market companies:
Control: Direct lenders will maintain close relationships with sponsors and management teams of borrowers after originating the transaction. Even if the loan experiences difficulties and defaults, a direct lender will continue to work closely with the borrower for a resolution. This stands in stark contrast to how banks operate. When a loan underperforms, banks send it to an internal workout team, which aims to remove the troubled asset from the bank’s loan portfolio, and not to help the borrower restructuring the business.
Speed of execution: The private equity landscape is increasingly competitive, and many sponsors are pre-empting sales processes to gain an advantage over other bidders. Therefore, sponsors are seeking direct lenders that can move quickly alongside them in submitting binding offers for investment targets. As direct lenders have smaller teams and more flexible investment approval processes than banks, they can offer the speed of execution that sponsors need in competitive sales processes.
Structural flexibility: Direct lenders have less rigid policies in place compared with banks and can provide more flexibility in structuring customised financing solutions. For example, direct lenders have shown flexibility in capital repayment, typically structuring a “bullet” profile so that 100% of principal is
