Direct lenders’ golden moment is over

After gold rush. downside of having a “golden moment” is that things can only get worse. That’s what direct lenders, or core of private-credit world that focuses on buyout debt, are finding little more than a year after Blackstone President Jon Gray pronounced a heyday for non-bank credit providers writ large. forces that boosted direct lending to roughly $850 billion in assets under management by end of 2023, using Preqin figures, are waning. It spells lower returns and partnerships with banking frenemies.

In pandemic’s wake, specialists like Blue Owl Capital, Ares Management and diversified giants like Blackstone and Apollo Global Management took a bite out of tritionally bank-dominated leveraged finance business. Direct lenders’ share of loans to highly indebted companies, including those owned by private equity, grew from 7% in 2018 to 17% by mid-2023, according to JPMorgan.

size of median loan rose nearly five-fold between 2014 and 2021, American Investment Council reckons, as industry’s largest funds jumped on beefy leveraged buyouts like Hellman & Friedman and Permira’s $10 billion acquisition of Zendesk. And because direct lenders typically use floating rates, yields surged as central banks hiked. net return on Ares’s Senior Direct Lending Fund II rose from 10% at end of 2022 to 15% a year later, roughly level typically targeted by private equity funds.

But heyday h as much to do with competitors’ weakness as direct lenders’ strength. In 2022, Wall Street players like JPMorgan, Bank of America and Barclays got stuck holding $80 billion of mostly buyout debt. That predicament, a product of fast-rising rates, ran counter to banks’ favored model of quickly selling loans to investors. It clogged up Wall Street balance sheets, giving private players free rein. As a result, about three-fifths of buyouts in 2023 relied on direct lenders, according to consultancy McKinsey.

Now, however, loan and bond markets have recovered thanks to central-bank rate cuts and absence of a recession. Deal-starved credit investors, like collateralized loan obligations, are hungry again. Public loan markets financed a larger share of buyouts by volume than private credit funds did in three months to September, reckons PitchBook LCD. Renewed competition from banks means direct lenders are having to offer lower rates. For private loans to large borrowers, spre over benchmark rates fell from 6.4 percentage points in early 2023 to 5.2 percentage points this July, according to ratings firm KBRA.

Direct lenders aren’t just losing out on new deals. Borrowers who h turned to private markets during golden era can now refinance at a lower cost in public markets, and so are able to play two markets off against each or. Some $22 billion of se refinancings happened this year in U.S. alone, PitchBook LCD data shows. Examples in Europe include French insurance broker April, which issued a public loan at a spre that was 2.5 percentage points lower than private borrowing it replaced. To hold onto business, direct lenders are having to accept lower rates. Italian pharmaceutical group Doc Generici managed to slash coupon on a recent refinancing deal with HPS and Blackstone, after banks tried to lure it away.

mittedly, direct lenders have some vantages that will endure, including greater speed, certainty and goodies like so-called delayed-draw loans, which borrowers can use to fund future acquisitions. non-banks also provide more leverage than regulation-constrained Wall Street players – typically up to a turn of EBITDA.

Finally, direct lenders can back companies with minimal free cash flow by measuring debt against recurring, sticky revenue. That gives m run of deals involving fast-growing software groups, like Blue Owl-led package for Smartsheet’s recent buyout. Meanwhile, those who have stayed focused on smaller borrowers too little to avail mselves of a syndicated alternative, like Bain Capital's lending arm, are still seeing highest spres.

Direct lenders and banks can work toger. Take possible $17 billion buyout of Sanofi’s consumer division. If it happens, that deal may rely on banks offering senior debt and private lenders providing riskier junior loans, toger bringing leverage to around 7 times EBITDA, according to a person familiar with matter. Pricing subordinated debt is hard, and re’s limited appetite for it in public markets, giving private credit an edge.

Yet even here, competition is tough. Direct lenders must deploy ir bulging pools of capital, meaning y're having to compete for same relatively risky deals. extra return over interbank rates available on low-ranking private debt has come down to around 7 percent recently, according to one banker. That implies returns can still exceed 10% or so, but only by taking more risk.

bigger private credit shops are best placed to cope with versity. Some can tap more liquid sources of funding, giving m access to cheaper capital. Blackstone has brewed up a private credit CLO, for example, while or players have ir own listed lending arms, like Ares Capital, allowing m to issue relatively cheap bonds. Ares has also gotten more involved in syndication process, as evidenced by its role helping to dole out part of a public-private loan package for Bain's $4.5 billion take-private of Envestnet.

Anor avenue is to partner more explicitly with banks. Apollo recently struck a $25 billion partnership with Citigroup, covering direct lending and private credit more broly, which should give Marc Rowan’s asset manager a continued flow of future buyout deals to finance. It’s generally easier for bigger direct lenders to seal se kinds of cooperation agreements, since y have funds to make it worth banks’ while.

giants of private credit also arguably have bigger fish to fry. Apollo is feeding balance sheets of insurers and annuity providers, including one that it owns, with credit sourced from new realms like asset-based finance. Rowan reckons that opportunity will easily eclipse size of tritional direct lending market. KKR, Blackstone and ors have different versions of same basic idea. Or large players, like Ares, also manage public loan funds, meaning y should benefit even if deals keep moving away from private market.

That means smaller players will feel worst of pain in new, leaner years. minnows are alrey struggling: top 10 private debt funds took over half of all new capital raised in 2023, according to Preqin. Those outside top 50 saw ir share collapse to 9% from 24% year before.

Still, big beasts can’t escape reality of lower yields. Even as y’ve diversified elsewhere, largest players are still sitting on vast amounts of money dedicated to direct lending. Investors have poured $138 billion into private credit overall this year, Preqin says, outstripping pre-golden era years like 2019 and 2018. With public markets roaring again, anyone hoping for a repeat of recent stellar returns will be disappointed.