Direct lending: finding relative value in a competitive market

Hannah: Direct lending. It’s a bit of a crowded space, to say the least. As the market gets more competitive, it’s more important than ever to listen to what investors want from their private credit managers.

In this episode of the PEI Private Credit podcast, sponsored by Manulife and reported by David Brooke, we speak with Greg Reynolds, partner and chief investment officer at Manulife Comvest Credit Partners. He explains how managers can stand out from their peers through effective sourcing strategies, good underwriting standards and robust portfolio management. We also explore why LPs might want to increase their exposure to non-sponsored strategies.

I’m Hannah Roberts, and this is the PEI Private Credit podcast.

*Music fades out*

Hannah: To start, it’s helpful to understand just how direct lending grew to be such a significant growth engine for the wider private credit asset class. Reynolds explains how regulatory changes and macroeconomic conditions created a perfect environment for the strategy to flourish.

[00:02:00.060] - Greg

Direct lenders really took market share from banks after the global financial crisis when regulations were tightening, capital requirements were increased, really forcing banks to pull back from leveraged lending, and direct lenders stepped in. They offered more leverage, they offered bigger hold sizes, faster execution, more flexible structures, and the returns were strong. Direct lending did well. The loss volatility was low. So as it continued to mature, not surprisingly, more and more capital came in. So if you look back over the last 10 years, direct lending has grown at about a 14% compound annual growth rate over that time. And then, even in the last 5 years, AUM in direct lending has more than doubled, which—an interesting part of this is it's all happened during a period of a sustained long-term bull market. So, as more and more capital came in, that meant more competition, especially in some of the really scalable parts of the markets, I think private equity-led buyouts. And over time, direct lenders competed more on price to win transactions.

Hannah: This heightened competition led to greater flexibility being granted to investors, but Reynolds says that there were knock-on effects for managers when it came to managing risk and loan protections – and some of those historical risks are only rising to the surface now.

[00:03:20.500] Greg

In addition to price, they started competing with more aggressive leverage multiples, or they accepted less due diligence access, and then somewhat more recently and very notably agreed to looser structures. So things like weaker financial performance covenants, sometimes no covenants at all. Diluted enforcement rights. They agreed to let a borrower pick some of their interest or a pick toggle feature. And then some of the documentation that's permitted what you'll hear referred to as liability management exercises or LMEs. So the ramifications of what I would call this risk-on behavior, which has largely been over the last 5 years or so, that doesn't necessarily show up right away, but as portfolios age, that's when underperforming credits will surface.

Hannah: Reynolds says that a combination of the higher interest rate environment, a wider realisation that generative artificial intelligence has the potential to disrupt certain business models, and a handful of asset-based deals being investigated for fraudulent behaviour, has created a sense of uncertainty in the investor community.

Greg:

And that's what really gives you the headlines. And it's also the formula for real performance dispersion between managers. Now to some extent, but I think also more apparently going forward.

Hannah: Manager dispersion is indeed a hot topic in today’s market. But how can institutional investors distinguish between what’s ‘real’ risk and what’s been reported in some newspapers over the past few months?

[00:05:06.420] - Greg

There's definitely been a lot of noise in the market, that is for certain. And I think things have started to die down from a headline risk to some extent recently. But I think that there's absolutely merit in some of the concerns around direct lending. So let me just walk through a few of them, a few of the headlines. PIK interest has gotten a lot of headlines, a lot of attention. And just to be clear, PIK interest is what allows a borrower to add its interest to the loan balance rather than pay it in cash. PIK accounts for about 8% of the interest income for those BDCs. And the key distinction that you need to make is between structured PIK, which is built into the original deal terms, and then what you'll hear people refer to as bad PIK, where a borrower is later on permitted to PIK interest because maybe it lacks the liquidity to make cash interest payments. So if I'm an investor, what I want to understand is what percentage of interest income comes from PIK. You know, no PIK interest is quote unquote good.

But you'll always have some level of PIK interest in a portfolio for a variety of reasons. But then you really want to understand how much of that PIK interest in a portfolio was structured into the deal at originations versus added through amendments or restructurings. So you really drill down on what I refer to as that bad PIK, because that bad PIK could be a sign of distress within a portfolio. So PIK is something that certainly you keep a close eye on. LMEs, or liability management exercises, a quick definition there. A traditional LME is an out-of-court restructuring transaction where typically a distressed borrower is going to use some of the flexibility that was built into the credit documents to, for example, raise new capital, extend its runway, reprioritize claims, often benefiting one creditor group versus another, or potentially siphoning value or collateral that should be part of a senior lender's collateral and putting it into an outside entity that isn't part of their collateral. It's been reported that about 80% of these types of transactions, these LMEs that happen through a restructuring, ultimately are going to end up defaulting again.

Hannah: Reynolds describes this practice as simply ‘kicking the can down the road’, adding that investors’ responsibilities in this space are fairly simple.

Greg:

They need to go to the direct lenders they're assessing and look at their exposure to LMEs on every transaction. It's going to be in their investment committee memos. It's going to be in their pre-close memos. So this is a due diligence exercise that I think you can do quite easily. to understand a manager's exposure to these type of provisions. And I think what you'll find is that those provisions are mostly in the upper middle market, or maybe some in the middle market in the more highly competitive parts of that part of the market. One other thing that's gotten a lot of the headlines, and I think is most notable, is the non-traded BDC redemptions.

And I think it's most notable because, and the reason why I gather the most headlines, is because there's retail investors in these vehicles as opposed to institutional investors. And just for some perspective here, non-traded BDCs, or what I would refer to more broadly as retail capital in the market, it accounts for about 15% of the overall market. So it's material, but it's not huge. Investors typically have the right within those vehicles to redeem on a quarterly basis, but managers can restrict those redemptions to typically 5% per quarter. Now, the redemption request really started when questions started surfacing around 2 things, one of which was valuations and marks on the transactions within those portfolios. And then exposure to software credits. So I'll touch on both of those briefly. When you think about valuations and loan marks, what an investor really needs to due diligence is how valuation marks are set, how often they're set, and they need to make sure that a manager is using a reputable third party that establishes those marks. And then on the software exposure side, and therefore, of course, the potential exposure to disruption of the business models from AI, obviously an investor should look at the software and technology exposure that a manager has.

Software, it's been roughly 20% of the average direct lender's exposure, much of it underwritten, by the way, when interest rates were lower and when there were very optimistic growth assumptions for these businesses in this sector. But also look at what resources a manager has to underwrite AI disruption risks. AI is clearly going to touch almost all industries. It's certainly software and technology is going to be impacted. but we think it's gonna touch virtually every industry in some way. And look at the quality that a direct lender has, the type of technical resources a direct lender has to evaluate AI risks, and then check if they have a very systematic approach to evaluating the risk, the AI disruption risk on every transaction they're evaluating.

Hannah: So, where does Reynolds see the greatest sources of manager differentiation emerging today?

[00:14:17.330] - Greg

Every direct lending portfolio has borrowers that are going to default. Those loans, they'll go to workout, and what you recover on those transactions is going to be the main driver of performance dispersion. And recovery rates really come down to a few things. Of course, the overall strength of the borrowers that a direct lender finances, the quality of the underwriting, how aggressively that deal was structured. How deep is the leverage? How deep is the loan-to-value ratios? And then critically, what protections the lender negotiated on the front end. So in the most competitive parts of the market, a lot of deals simply don't have the covenants strong enough to give a lender a seat at the table before value has already degraded to a certain extent. So you'll see credit agreement provisions restricting a lender's ability to enforce their rights and remedies, for example. You know, a specific example of that would be a lender has a right through its pledge of the borrower's stock to vote a proxy of their shareholders to change out the board of directors.

But there are some provisions that lenders agree to, quite commonly in fact in certain parts of the market, that really greatly limit their ability to enforce that typical senior creditor right and remedy. And there's a lot of different flavors of these concessions, all of which have the potential to negatively impact recovery rates. And then one other critical piece of this is the lender's capacity to manage distressed deals. You know, the economy has been good. There hasn't been a lot of defaults. And when a cycle turns, if it's like prior cycles, lenders will need the skill set and the bandwidth to work out of multiple positions at once. So to summarize here, I think we're still in the relatively early innings of manager performance dispersion, and that dispersion will come largely from recovery rates. And where there was some pretty aggressive behavior by lenders agreeing to things such as loose or no covenants or compromised enforcement rights, you will see some level of weaker recoveries, and that'll be a big source of manager dispersion.

Hannah: In short, the market is still in the relatively early innings of seeing significant dispersion in manager performance, though that may come later in the form of recovery rates. So what kind of opportunities is this environment throwing up for managers that are able to navigate the complexities of this market? Is there much opportunity available?

[00:17:12.040] - Greg

Without question, there is significant opportunity right now. There's a stat out there that says that almost half a trillion dollars of private credit debt will mature over the next 2 or 3 years. And a lot of these deals that need refinancing, these are the deals that were done at the peak of the market, such as the 2021 vintage, when sponsors were paying peak valuation multiples. They were financing their acquisitions with high leverage multiples that seemed more appropriate at the time in a period of low interest rates. And lenders with flexible mandates—think about opportunistic credit providers—they can really thrive here. And it's pretty widely known that private equity is looking to return capital, not invest more capital into these longer-dated deals. So there's strong demand for the type of capital that can solve that overlevered balance sheet that you see in a lot of transactions from the most aggressive vintages like that 2021 vintage that I mentioned. Another tailwind, so that's opportunistic credit. Another tailwind that's just in the general direct lending industry is worth noting. We talked about non-traded BDC redemption pressure. So if that persists, the supply and demand dynamics get healthier.

Hannah: To this point, Reynolds points out that the less capital there is chasing these deals, the greater potential there is for wide spreads and stronger lender protections and covenants – but only if the M&A markets recover.

[00:18:33.390] - Greg

We have seen some indication of this over the last 9 months or so. if and when the M&A market heats up again, that would definitely further improve that supply and demand balance that I was describing in direct lending. But we have been hearing that story for a while now. It hasn't materialized. So we'll see if the M&A market heats up significantly. We do know there's a significant backlog. Private equity needs to get out of transactions, return capital to their investors. But as of yet, we've really yet to see that M&A market really open up to the extent people had forecasted.

Hannah: These specific dynamics do depend on which area of the market lenders are focused on, however.

Greg:

People would agree that the core middle market, sponsored finance, upper middle market, those are the most crowded segments. And in some cases, for very good reasons. But certain segments of the market, if you think about specialty lending, for example, so the asset-based finance world, and then lending to maybe it's a non-sponsored borrower, there's definitely less trafficked segments of the market.

And that also happens to be where covenant protections can be the strongest. So there's opportunity there as well. But overall, we're very bullish on the market at this point in the cycle. And I think if you look at institutional demand for the asset class right now, Institutional investors are also very bullish right now as well. I think Q2 was one of the stronger fundraising quarters in the last several years for institutional fundraising. So, for one thing, and I think the reason why they find it so compelling is part of that is the redemptions in the non-traded BDCs. But also, at this point in time in a potential economic cycle, being at the top of the capital structure is a pretty good place to be. And when there's volatility, you should see lenders behaving more rationally. So you could see higher stream rates, and you should see an improvement in overall loan terms to the extent you see volatility, and there's less of that risk-on behavior and a little bit more of a risk-off behavior in direct lending in general.

Hannah: Now, to the topic of origination. How much does Reynolds think sourcing will become an important differentiator going forward?

[00:23:24.950] - Greg

You know, originations differentiation is hard, honestly. It's hard to point to direct lenders that have a different mousetrap or a better mousetrap. But you can see some differentiation coming from the depth of the relationships a direct lender may have and also the breadth of relationships. So if you start with the depth of relationships, there are direct lenders that have established very strong relationships with certain private equity sponsors. So they'll see most, if not all, opportunities from their best relationships. And based on that relationship, the hope is that they'll win a disproportionate share of those financings. So there can be a material real edge there based on the depth of relationships that a manager might have.

Hannah: Reynolds does have a word of caution for investors on that last point, though.

I think if a sponsor's portfolio company underperforms, you have to ask if the lender will defend its position as aggressively as maybe it should, knowing it wants to see that sponsor's next deal. So, you definitely have a bit of a conflict there. And then, so, in addition to the depth of relationships, I think you need to look at the breadth of a direct lender's origination sources. So broader originations networks that get deals from alternative channels, such as, you know, some lenders get a lot of transactions through commercial banks, they get them through service providers, law firms, accounting firms, or smaller advisory firms.

If you go through these channels, you can get access to opportunities that might have a little bit less intensive of a competitive landscape. So maybe a direct lender's established direct relationships with management teams in particular industry subsectors that that lender specializes on. That can be a real edge as well. I think the bottom line on originations is the wider the funnel, the more selective you can be as a lender. So personally, I would lean toward the benefits of a multichannel diversified approach to originations. But I can see the merits to a more concentrated model that's building deep relationships with a core set of private equity sponsors as well.

Hannah: But there are risks to consider when it comes to working with just one sponsor.

[00:26:10.790] - Greg

You need to look at portfolio construction in general in a variety of different ways, and one of which is potential concentration within private equity firms. They may have an investment philosophy, they may have an investment theme that they're pursuing across multiple investments. There could be some correlated risks within their different investments. And so, if you're heavily concentrated with one sponsor, there is a potential to be caught up in some level of maybe unforeseen concentration within that portfolio with that one specific sponsor. And then, as I mentioned, I think you need to take a look at the potential conflict when a direct lending manager is managing one of those credits that doesn't perform particularly well, are they going to maximize the outcome for themselves on that deal, while they're also keeping an eye on future deal flow and the overall relationship with that private equity sponsor?

Hannah: It sounds like managing all of these priorities will be a delicate balancing act for investors. Another key aspect of the direct lending conversation is the perception that non-sponsored lending is riskier than sponsored lending. But is that a fair characterisation of LP sentiment?

[00:27:35.130] - Greg

Well, I would say, all else being equal, you would absolutely rather have a business that's owned and controlled by a traditional private equity firm. You know, sponsors, they bring quality governance. They have industry contacts. They have more capital to invest in that business if needed. And that's powerful. That's very powerful. But it isn't the whole story. So maybe when you look at non-sponsored lending, we'll look at the negatives, we'll look at the positives. So negatives, it's hard to originate those deals. But it's also much harder to underwrite. So you need, if you're a direct lender, you need industry resources and expertise. You don't have the private equity sponsor there doing the due diligence for you. So the underwriting is very labor-intensive. And then there's the question of what happens when a non-sponsored borrower needs equity capital, when they have a liquidity need. Although I would say, and this has been our experience, If you're financing a mature non-sponsored borrower with, say, I don't know, $25, $50, $75 million in EBITDA, and there's a mature business that's been generating that level of profitability for quite some time now, the equity owners of that business likely have a lot of capital to support that business if need be.

And don't forget that in sponsored deals, sponsors might put in rescue capital into a business, but they need to get a return on equity on their transaction for doing so. And if they do put in additional capital, it's going to be— it's going to require some major concessions by its lenders. So, just something to keep in mind when you look at that dynamic of additional capital.

Hannah: Reynolds says that one of the biggest opportunities associated with lending to a non-sponsored business is that investors will receive a yield premium.

Greg:

That can be 100, 150, 200 basis points, more. It can be very material. You should be lending at lower leverage multiples. You should be lending at lower loan-to-value ratios. And you should be getting much stronger structural protections. So better covenants, better reporting, better information rights, better overall enforcement rights. And then I would point to one other thing, which is the opportunity set in non-sponsored lending is actually quite enormous. I saw a stat the other day that said that for US middle market businesses, only 20% of those businesses are owned by private equity firms. 80% of the businesses in the US middle market are non-sponsored.

Hannah: So does he have a bottom-line take on which is better?

[00:30:17.130] Greg

I think you can make a compelling case for both sponsored and non-sponsored lending. Both have done well. Both should continue to do well. There could be more volatility in both those asset classes, but I think they're both well positioned to continue to generate strong risk-adjusted returns. But I think I would say that the non-sponsored lending is definitely a harder segment in the market to execute on for a direct lender.

Hannah: He points to the additional value of having flexibility and diversification by engaging with both sponsored and non-sponsored strategies.

[00:31:25.900] - Greg

If a manager is lending to both sponsored and non-sponsored borrowers, that manager can lean into whatever segment of the market is offering attractive relative value at any given point in time. So right now, for example, the M&A environment is pretty sluggish, and because sponsored direct lending really feeds on M&A activity, sponsored lending is quite competitive right now. That's certainly no secret. Whereas the demand drivers for non-sponsored lending are very different compared to sponsored lending. So non-sponsored lending demand is going to be much more of a diversified set of reasons why there's demand from those borrowers. It can be growth capital, it can be estate planning purposes, it can be an add-on acquisition or just a typical refinancing. So, yes, the 2 asset classes can be very complementary, particularly in a market like the one we're in today. And then the question around what to look for in a non-sponsored lender. So, an originations engine, it clearly should be first and foremost, can that manager find these transactions?

Hannah: Reynolds reiterates the benefits of having a wide funnel of opportunities to consider when it comes to evaluating the make-up of a direct lending portfolio.

Greg:[00:32:52.560]

You're looking for the non-sponsored business that has that diversified, durable business model with a very high-quality management team. That's not easy to find, and you need to be highly selective. Your hit rate is going to be low. So, you need to look at that originations engine. And then you need to look at, does the manager have the resources and the expertise and honestly, just the willingness to replicate the type of comprehensive due diligence that a private equity firm would do? Which really, if you don't have that, you're exposing yourself to significant credit risk. And then you look at, does the manager have the portfolio management resources, specifically workout and restructuring resources and expertise needed to manage a non-sponsored portfolio? You need those resources with both sponsored and non-sponsored lending, but I think they're particularly needed when you're lending into the non-sponsored space.

Hannah: Is there a perfect balance for a portfolio when it comes to sponsored and non-sponsored strategies?

[00:34:15.760] - Greg

I do think it depends on the type of manager because, as I referenced, I think some direct lenders are set up and resourced to manage lending to a non-sponsored borrower, which requires much more resources, certainly, but also just the willingness to have a much longer due diligence process. It's not a very scalable business model, which many direct lenders that are focused on the sponsor side of the market and trying to very robustly deploy their investors' capital, sometimes the direct lending model into the non-sponsored world is a tough fit for those particular managers.

Hannah: Now for a final, very important question. What does Reynolds think are the three most important questions allocators should be asking of direct lending managers today?

[00:35:15.180] - Greg

At first, I think kind of the basics. I would ask about how the manager manages portfolio construction in general. So what concentration limits do they have by borrower, by industry, by subsectors, by sponsor, like we talked about before, by different types of correlated risks? What tools do they have to monitor these things on a real-time basis? It's all pretty basic, but if you look at some of the trouble spots in direct lending recently with certain managers, there's been some examples where managers have failed to diversify properly. So, I would start with the basics on diversification, and also how a manager tracks that diversification and how they set their portfolio construction goals. Second, I would ask about where they sit in the capital structure: first lien, second lien, and so forth. And that sounds pretty simplistic, but you need to drill down to the next layer there as well. So, first liens can sometimes be shared with other lenders, for example. So, for example, you might see a transaction where a big bank has a revolving line of credit in place with the same borrower, and they're either sharing a lien or splitting up the liens on the assets.

So you need to understand how much fits into that profile. And then I think you need to be a little bit careful about what someone might call first lien. Because if leverage is really high, some of that risk that the manager is taking is really mezzanine risk with a senior debt label upon it. So I think you need to look at how deep they're lending. Look at their average leverage multiple. Look at their average loan-to-value ratio. Be careful with that definition of average loan-to-value ratio because valuations are something that you need to be careful on how they're calculated, and you need to also look at, you know, what's the durable value of a business if things aren't going well? Because a lot of times there's businesses with high valuation multiples because maybe that's based on particularly high level of growth in an industry or expectations maybe that a new product category is going to really take off. Well, what happens if those growth prospects don't materialize. That's where you get really into what's the durable value of a business. So be careful with loan-to-value ratios, but also look at how deep a lender is lending, both from a leverage and a loan-to-value perspective.

Hannah: There one thing that Reynolds thinks flies under the radar when it comes to asking managers about their processes.

[00:39:49.640] - Greg

You know, one of the things that we think is important, look into how often the lender is the lead administrative agent on their transactions. Because a lot of times, if you're not the lead lender, you're at the mercy of the lead lender that may not necessarily maximize the recovery on a loan if you run into trouble. So maybe that lead lender is conflicted in some ways. We talked about the potential that some lenders have of having relationships with private equity sponsors, and maybe because they're so reliant on that private equity sponsor for deal flow, they may not manage one particular transaction as aggressively as maybe they should. Another thing I think just maybe a bonus one, look at how much overlap there is from one lender to another, to another manager. And in the sponsor finance world today, it's very much what's referred to as a club market, meaning that lenders are getting paired up together on loans. So there can be a lot of overlap on specific deals for different direct lenders. And club deals also creates the ingredients for consensus risk. So a club of lenders typically isn't going to act as decisively as a sole lender would when managing a particular credit. Consensus risk is probably something that gets understated when you look at the risks of how lenders manage their portfolio companies.

Hannah: That's all for today. Thanks again to Greg Reynolds from Manulife Convest Credit Partners for joining us. If you want to hear more episodes, you can search wherever you listen to podcasts or at PEI-privatecredit.com. This episode was reported by David Brooke, produced by Edward Cleaver and edited by Eric Fish. And I'm Hannah Roberts with PEI Group. Thanks for listening.

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