Lending lowdown Podcast

Navigating the direct lending market

Episode 9, Season 1

US direct lending activity was robust and resilient in 2022, despite an uncertain economic environment. What’s in store for 2023?

Host CJ Doherty and guest Diana Diquez talk about recent trends in the direct lending market as lenders navigate changed market conditions.

Host: CJ Doherty

  • CJ Doherty: Welcome to the Lending Lowdown. I'm CJ. Doherty, Head of market analysis. And I'm joined by Diana Diquez, director of analysis here at LSEG LPC. We're excited to bring you our 9th podcast in the series. So thank you, everybody, for tuning in. Today we're going to talk about what's going on in the US. Direct lending market. We all know that last year was a challenging one for the broader capital markets. Yet through it all, direct lending was resilient and deal flow held up a lot better than in the broadly syndicated market. And this segment of the loan market has grown exponentially in recent years. And Diana, you've been covering this market for a while now.

    Diana Diquez: Yes. Hi. CJ. I have been covering in the direct lending market for a few years now. And it's been fascinating to see the growth through all these years. I mean, just to give you a little context, last year 80% of middle market LBOs were done in the direct lending space. And if you go back to 2014, only a third were financed in that market back then. And through the years, we've seen direct lenders move up to the large corporate market as well. And last year, actually 45% of overall markets LBOs were financed in the direct lending space. And as you see, that's incredible, incredible growth. But we do have to say, CJ. That last year the market was not completely immune to what was going on in the world. And we did see a slowdown, but as you mentioned before, it was a lot more moderate than the syndicated markets. But that was last year, right? We're here today to talk about what's happening now. Yeah.

    CJ Doherty: And while at the moment the market is looking a bit sluggish, lenders say 2023 to date has been slow in terms of deal flow and also pipelines are looking quite thin. But some direct lenders say they are hopeful of a pickup in activity as the year progresses. But it's by no means certain. While there are variations across firms, one lender mentioned that the number of deals in their pipeline right now is about a fifth of what it was a couple of months ago. And one of the reasons behind this is after years of, let's call it easy fundraising, the environment has changed. It's now more challenging to raise funds.

    Diana Diquez: Yeah, I mean, that's correct. But we do know the asset class remains very attractive. Right, but interest rates are a lot higher now and that really means that there are many other places for investors to put their money in. And you know what? Some of those other places offer great returns and they might consider those safer investment at this time. And there's also another part of this and it's that it's become lot harder to get money from international investors given how strong the dollar is.

    CJ Doherty: Right. Diana so I think we can characterize the market as being more selective and cautious. Direct lenders are getting a lot of inbound calls about lending opportunities still these days, but they say their rejection rate has gone up. So given the economic headwinds we see, plus the fact that some lenders are more capital constrained this year, they're either not putting money to work at the same pace or are decreasing their hold levels. Nevertheless, though, that's not to say deals are not getting done. They are there are still lenders out there able and willing to put money to work for deals they find attractive.

    Diana Diquez: Yeah, and what we've seen is that many of these lenders have been getting into deals that before they didn't have a chance to. And also that means that right now it's a really good time for them to make new relationships with some sponsors. And that's because they're getting calls from sponsors that before would not have given them the time of the day.

    CJ Doherty: Right. And another positive amid the broader economic uncertainty is that if a deal that lenders likes comes along, they're able to get much more attractive risk adjusted pricing than a year ago. So arguably this is a good vintage right now.

    Diana: Diquez: It really is. CJ, I mean, look at the terms right now. They're super favorable for lenders. And just look at the yields we're seeing maybe 1213 percent for unitranches, sometimes even 14%. And more interesting is that those higher yields are not only the result of rising interest rates, we've also seen spreads and OIDs widen. I did hear recently from someone that OIDs might be tightening a bit. But again, the deals that are getting done are very high quality ones right now and many lenders want a piece of them.

    CJ Doherty: And for lenders, the good news is not only the higher yields that you mentioned, documentation and other deal terms and metrics like loan to value on new loans have shifted more in favor of lenders. And the reality is that too, is that we've seen this shift occur pretty fast.

    Diana Diquez: Yeah, I know, right? For a long time, sponsors were basically dictating terms. Like if one direct lender didn't want to do a deal at the leverage that the sponsor needed or at the price they needed, they would just move on to the next lender. Now it's really different. Lenders have a lot more bargaining power. So we've talked about like there's a good amount of lenders looking to put money to work, and they're getting great returns and great terms. So the question is, why are things so slow right now?

    CJ Doherty: Right. Well, what we see happening, and we touched upon it earlier, is that deal flow, or more specifically, higher quality deal flow, is much more limited. There's not. A ton of these deals out there right now. And I think contributing to this is that the cost of debt is very high for sponsors at the moment. Lenders are giving out a lot less leverage. A deal that was done at seven times leverage before is now getting done at five times. This is because lenders are now structuring deals off interest coverage. You want to have that ratio at a minimum of one and a half times. So the math will not work at seven times leverage.

    Diana Diquez: Yeah. And on top of this, we have seen a slight contraction in purchase prices, but there's still that big disconnect between buyers and sellers expectations. I mean, sellers still want very, very high multiples. And as you mentioned, with debt being so expensive but more limited, sponsors now have to put a lot more money in. And you know what the reality is? They're not going to do this for every deal. Right? Especially in this environment.

    CJ Doherty: Yeah. So LBO activity has started slow this year, and we've also heard that some add ons are challenging. One lender mentioned that they're getting approached by some sponsors for add ons on deals that were done originally at seven times leverage. And even though doing the add on means the pricing will increase to the current level on the existing deal, which is a good thing, in some cases, that's not enough. Lenders generally don't want to be part of a seven times lever deal in this environment.

    Diana Diquez: Yeah, definitely. I mean, it's hard given where we are now. So given that LBO activity and add on activity have slowed down a lot this year, we really expect this quarter will end up being a slow one for sure. But what happens beyond the first quarter, I find it really hard to tell. And I've talked to some people and I've heard very different views. Some say, well, we're pessimistic and don't really see things changing. But then there's others that are a little bit more hopeful, and they say they do expect an improvement, but maybe it's going to be in the second half of the year.

    CJ Doherty: Yeah. One important thing to mention is that in this economic environment, which is marked by inflation rate hikes in the last year and fears of recession, lenders have been spending more time on their portfolios this year and closely monitoring them. So far, though, portfolios have held up pretty well. We haven't seen any major pickup in nonaccrual rates yet, even though base rates have climbed sharply and interest coverage ratios have declined. If we use take one BDC as an example, Ares Capital Corp. Recently reported nonaccruals at 1.7% in the fourth quarter of 2022, and that was only up marginally from 1.6 in the prior quarter. And this rate remains well below the ten year average of 2.4%. And it's actually the same for amendment activity. It's remained limited overall, though it's expected to pick up in future quarters.

    Diana Diquez: Yeah. I've heard the same thing. Because if you look at it, in reality, we won't be able to see the full effects of rising rates and other macro pressures in the numbers until maybe June. So at that point is when we'll probably start seeing some portfolio cracks. Right now, companies can pay. Their interest. But what if revenues dip? Then what happens? There are just so many unknowns right now, and we do know that the outcomes will vary company to company and sector to sector.

    CJ Doherty: Yeah, there's a lot of uncertainty out there, but lenders say it's manageable. They point to the various ways they work together with sponsors when companies run into difficulties. But we'll have to wait and see.

    Diana Diquez: Well, we definitely have a challenging year ahead, but we'll continue to track this market closely and be on top of all these developments.

    CJ Doherty: Indeed we will. And on that note, we'll wrap it up for today. Thanks, Deanna. And thank you all for tuning in. I invite you to check out our private debt analysis at loanconnector.com. Follow us on Twitter at LPC loans. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.

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