loans at a discount to par sourced both privately and on public markets (secondary purchase).
2.3.2 Market Growth
For direct lending into complex situations, transactions are sourced directly from middle-market companies both in the US and in Europe. We anticipate that a certain percentage of middle-market firms will experience a complex situation requiring an opportunistic credit solution. Under normal circumstances, an estimated 5% of middle-market borrowers will require customized opportunistic financing, leading to a market size of more than USD 80 billion, potentially increasing during an economic downturn.
For secondary situations, market opportunities arise in the syndicated loan market. Based on a market size of USD 1.61 trillion,[6] and assuming that on average 22% of loans trade below 80% of par during a recession, as demonstrated in the GFC, we estimate the market for opportunistic lending to be approximately USD 350 billion. To profit from secondary opportunities, managers must have sufficient capital at hand and be able to act swiftly.
There are several drivers supporting the growth of the opportunistic lending market:
Borrower experience of private debt: Given the increasing prevalence of direct lending in the middle market, borrowers (in certain complex situations) are gaining a more detailed understanding of non-bank financing and becoming more open to opportunistic lending, especially given the lack of other options.
Post-COVID-19 environment: The borrower-friendly environment prevailing before the COVID-19 outbreak pushed leverage to pre-GFC levels; most leveraged loans were covenant lite. The increased uncertainty about future economic conditions as well as liquidity concerns could trigger further downgrades and exacerbate outflows of capital, particularly from CLO investors, in the leveraged loan market. This would lead to some value dislocation from credit fundamentals and present investment opportunities on the secondary market for selective managers.
Bank deleveraging balance sheets: Within Europe, regulatory reforms through Basel III have increased capital requirements for banks. As sub-investment-grade corporate risk attracts the highest capital charges, banks are motivated sellers for these assets to meet the capital requirements. In 2016, European banks held an estimated EUR 700 billion in non-core corporate loans.[7] This represents a significant source of potential deals for opportunistic lenders.
2.3.3 Risk-adjusted Returns
Below is a simplified method to understand the return drivers for different transaction types within the opportunistic lending segment in 2020.
Table 1: Return Drivers by Transaction Type
| Transaction Type | Upfront Fees/ Discount to Par | Margin | Hold Period | Gross IRR |
| Direct Lending into Complex Situations | Upfront fees: 2 to 3% | 700 bps + | 6 months to 3 years | 10% + |
| Secondary | Discount to Par: 15 to 20% | 350 bps + | 6 months to 5 years | 13% + |
Source: StepStone estimates
The key levers behind the target IRR for the opportunistic deal flow are (i) upfront fees/discount to par, (ii) margin and (iii) hold period. Other factors that can boost the IRR are triggering call protection, exit fees, and preferred equity/warrants as part of the structure.
The return range will also vary depending on where the investor focuses in the capital structure. For example, the return for first-lien transactions will be at the lower end of the range, with returns increasing as you descend the capital structure to second-lien transactions.
Our expectation is that loss rates will largely reflect the syndicated loans, first-lien and second-lien direct lending of 0.7%, 0.8%, and 1.6% respectively, with an additional premium of 0.3% to 0.5% for complexity.
2.3.4 Investment Considerations
We observe that the deal volume for direct lending into complex situations is relatively consistent through an economic cycle with a potential uptick during a downturn. Complex situations arise through idiosyncratic as opposed to systemic risk. For secondary transactions, the deal volume will significantly increase during periods of market volatility and is heavily timing dependent.
For the reasons exposed above, we deem it important to diversify across different credit strategies within opportunistic lending to achieve target returns throughout the cycle, while accessing enhanced deal flow and returns during a market downturn.
2.3.5 Outlook
As investors build up experience and expertise within the private debt asset class, they will try to diversify their portfolios with other sub-strategies. Opportunistic lending offers a more attractive risk-adjusted return profile for investors looking to expand their portfolio beyond a pure play on direct lending. The COVID-19 crisis will provide an extended opportunity set and could serve to demonstrate the relevance of this strategy in a well-diversified portfolio.
Opportunistic lending is also likely to attract private equity investors seeking double-digit returns but with a lower risk profile and the downside protection provided by debt financing structure, especially in a late-cycle environment with high valuation multiples.
2.4 Co-Investment and Secondaries in the Corporate Private Debt Space
For most of its limited history, private debt (direct lenders in particular) provided facilities to companies in the lower and middle markets, where loans are typically too small to be of interest to a lending syndicate. As the asset class has grown, however, some private debt managers are seeking partners so they too can lend to the upper end of the market.
There are two primary options when it comes to finding partners:
The first option follows the co-investment model that has become popular among private equity investors. Here, the GP identifies one or two like-minded partners – often a Limited Partner (LP) – to provide the capital necessary to close out a deal.
The second option is the club deal whereby the private debt manager looks to put together a small syndicate made up of four to six co-lenders. Club deals are attractive because they can accommodate larger deals than co-investments can.
However, because the syndicate is often made up of competitors, club deals can be complex, resulting in greater governance risk. In fact, lack of alignment is one of the reasons private equity managers soured on club deals and moved toward the co-investment model. By some estimates, co-investments
