the borrower to use its free cash flow to grow the business as opposed to repaying principal. Direct lenders also exhibit more flexibility than banks in the negotiation of key terms in loan agreements. Greater flexibility can also be provided during the life of the loan would the issuer face an adverse situation as demonstrated during the COVID-19 crisis. For instance, direct lenders quickly agreed to suspend or postpone interest payments for companies confronted with liquidity issues.
Business partners: In the case of non-sponsor transactions (i.e., with no private equity firm involved), direct lenders can provide support to management teams in addition to debt capital. Like private equity firms, direct lenders can give management teams access to their relationship networks to access more customers, sector expertise, more supplier relationships and operational experts supporting the companies’ financial and operational performance.
2.2.4 Investment Risks and Considerations
When assessing direct lending strategies, investors should not neglect the investment risks particularly toward the end of an economic cycle.
During the last 10 years, valuation multiples gradually increased with the expansion of the economic cycle. In turn, sponsors steadily pushed leverage levels up in line with pre-GFC peaks to compete in sales processes and meet valuation expectations. Even though leverage levels were steadily increasing in line with valuation multiples, sponsors increased their equity cheque at a faster rate over the period. Hence, the cash equity cushion below the debt in the capital structure typically remained in excess of 45%, in line with post-GFC figures.
Key terms such as “covenant headroom” and “EBITDA adjustments” are gaining importance in borrower-friendly environments. The importance of data as well as deeper analysis of direct lenders’ term sheets and financing structures is critical to understanding the genuine risk profile investors are taking. Covenant headroom can be compared to a margin for error granted to borrowers when defining the covenant level. It is formally the relative difference between the level of a financial metric at origination and the agreed covenant level.
In most cases, covenant headroom decreases over time, as covenants tend to be stricter over the life of the loan. EBITDA adjustments, or the practice of taking credit for cost savings and other pro forma adjustments, became popular in the past few years. By overestimating a company’s profitability, these adjustments skew the valuation calculus, making companies seem less expensive than they really are. In turn, it becomes much easier for a sponsor to lever up the company. While private equity sponsors have become more creative in how they define EBITDA, direct lending GPs (and co-investors) must rely on a quality of earnings report. Published by reputable accounting firms, these reports help the sponsor and lender determine which adjustments should be added back to EBITDA and which should be excluded.
Exhibit 4: Average covenant headroom for first-lien Direct Lending deals
Source: StepStone Private Debt Internal Database, based on more than 8,000 US and EU first-lien loans
Exhibit 5: Average EBITDA adjustments for first-lien Direct Lending deals
Source: StepStone Private Debt Internal Database, based on more than 8,000 US and EU first-lien loans
During economic downturns, banks often have little or no ability to underwrite syndicated leveraged loans causing a liquidity shortage for middle-market companies. Direct lenders with ample dry powder to invest are well-placed to fill the gap left by banks. Due to the reduced competition, lenders should be able to negotiate more lender-friendly terms, such as higher pricing, lower leverage, more covenants, less covenant headroom or EBITDA adjustment. Although the consequences from the COVID-19 crisis are still uncertain, some first observations can already be drawn. After a massive reduction of deal flow, one could observe more lender-friendly terms in the first post-crisis transactions. StepStone observed a pickup in pricing combined with lower leverage level, price multiple, covenant headroom and EBITDA adjustment.
2.2.5 Outlook
The rise of corporate direct lending may have coincided with perhaps the longest economic recovery ever, but this success is here to last. Even though it is too early to gauge the consequences of the COVID-19 outbreak on direct lending, we believe the asset class will continue to capture market share from banks for several reasons:
Continued bank disintermediation: Traditional banks appear likely to continue focusing on large corporations, shying away from borrowers at the lower end of the market. This allows direct lenders to remain focused on small and middle markets, prolonging the trend of banking disintermediation.
Direct lenders’ ability to execute larger transactions: As GPs raise more capital, they will eventually compete with the leveraged loan market for larger deals. In Europe, we have already seen some GPs pursue billion-euro transactions.
Sponsor preferences for direct lenders: As previously stated, direct lenders can offer more flexible terms than traditional lenders. Private equity GPs have taken note and increasingly turn to credit managers to finance acquisition bids. Direct lenders also know borrowers more thoroughly than banks do, gaining greater insight into each borrower’s idiosyncrasies as a result. In this way, direct lenders are better able to help private equity GPs recapitalize their portfolio companies if needed.
Non-dilutive growth capital: Family- and founder-run businesses are gradually developing an appreciation for private debt. They used to view direct lending as just a more expensive lending solution but have come to regard it as a non-dilutive source of capital to increase valuation to an exit.
Migration of talent: During private debt’s rapid maturation, there has been a gradual shift of talent from banks to debt funds. We believe this trend will continue, further undermining banks’ ability to compete for market share.
2.3.1 Overview
Opportunistic lending covers a broad spectrum of credit strategies. A simplified approach to visualizing this market segment would be to compare it with more mainstream strategies and products, as shown in this section.
Exhibit 6: Opportunistic Lending
Currently there is a market opportunity in the financing gap for borrowers seeking funding at a cost of capital of 10 to 15%. An increasing number of private debt funds are raising capital to provide a solution for these borrowers. The COVID-19 pandemic has created a favourable environment for opportunistic lenders as many borrowers are expected to go through challenging times. For managers with sufficient dry powder, short-term market volatility may also present interesting opportunities.
The sub-strategies include:
direct lending into complex situations such as growth capital, refinancing of overleveraged balance sheets, time-sensitive events, shareholder restructuring, challenging sectors and hung syndications inter alia;
acquiring
