BLOG — Apr 21, 2021
Direct lending: Are the rules changing?
I recently participated in an expert panel hosted by SuperReturn Europe during which I had an opportunity to exchange insights on direct lending with a group of investment managers and technologists focused on private debt. In this post, I share some of the insights gathered during this session.
Revelation amidst the credit cycle
It can be tempting to assume that the state of play in direct lending has been significantly changed as a result of the pandemic. But in many ways, what we have seen is that the market works and has, in fact, matured more rapidly due to the pandemic.
With the advent of Dodd-Frank, many banks have been regulated out of all but the largest deals, creating a broad and deep opportunity set for direct lenders. Private capital has risen to the challenge: in 2020, it showed less volatility and greater resiliency than much of the liquid debt market.
My takeaway from the panel and conversations with sponsors is that the past year has been an opportunity for firms to stress-test portfolios and for investors to gain a deeper understanding of manager discipline as well as the strength of their underwriting.
A maturing market
Just prior to the pandemic, direct lenders had some of their best years for fundraising. As a result, sponsors were able to write bigger deals and, in many cases, came together on club deals to provide greater liquidity. It also meant that the private debt market as a whole was better resourced during the initial tumult created by the pandemic. These trends reinforced the value proposition for direct lending.
By going through the private debt market, companies are able to get customized financing with a single lender or a small group of lenders, while avoiding the uncertainty of loan syndication and the volatility of the high yield market. Direct lending relationships also tend to be long-term and strategic, which provides a level of certainty for business owners and investors alike. These are meaningful benefits in all market environments, but especially during times of crisis.
Sponsor discipline remains critical
Risk aversion has increased among sponsors in response to the pandemic. This has led to a tightening of terms and contract amendments designed to mitigate risk throughout lending portfolios for credits that have been negatively impacted. That's a net positive for investors in these funds.
But there is also some indication that significant portions of portfolios have continued to perform well, especially those with exposure to software or healthcare companies that have outperformed in the pandemic. The long-term and strategic viewpoint of direct lenders has resulted in portfolios that can withstand the pressure of a few choppy years. Maintaining this credit selection discipline will be critical to the stability of the private debt market over the long term.
Better data and disclosure are still needed
The shift to remote working in response to the pandemic has underlined the need for better data and disclosure from sponsors and portfolio companies to their lenders, who are then providing more disclosure to LPs. In lieu of traditional site visits and in-person presentations, investors have pivoted to more data-driven processes and a greater reliance on software. GPs have had to catch up quickly and there is still more to do.
GPs realize that their LPs appreciate expedient transparency and now more than ever before that requires software to optimize workflows for capturing and databasing investment details, cash flows and performance trends. Internally that also means improving data quality to help mid- and back-office teams access reliable, up-to-date investment data to easily meet reporting requirements with reduced disruption to their ongoing tasks.
Working with a managed data services provider can solve many of these issues. Managed data services can create digital copies of financial packages, establish approval workflows and provide 24/7 visibility for reporting and analysis. This avoids having to search for information and prevents mistakes that lead to data quality issues.
Technology can also be useful for databasing cash transactions and preparing performance calculations and financial statements to review KPIs. Together, this provides a holistic view of a credit, a portfolio and the associated performance in a reliable fashion.
As sponsors consider the post-pandemic market environment, it's likely that much more of the day-to-day business of direct lending will happen online. Going forward, sponsors will need to carefully consider long-term technology solutions and engage with third-party providers that can help them scale up quickly and formalize digital workflows that are sure to persist even after we return to normal.
So, are the rules changing for direct lending? In summary, I would say that while the rules remain the same, the interpretation of risk, the deployment of technology as a competitive advantage and the need for greater discipline when underwriting are all changing.
S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.
This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.