January 31, 2025
Direct Lending in 2025: Find Less Crowded Spaces
by Tony Cappell and Kushal Kshirsagar
Over $480 billion has been raised by direct lending strategies between 2019 and 2024 H1. (Source: PitchBook Data, Inc., June 30th, 2024). The lion’s share of these flows are being captured by the largest private credit managers and the largest direct lending funds.
These large funds primarily lend to middle and upper middle market PE owned companies because that is how they can efficiently deploy tens of billions of dollars. They follow the same capital deployment protocol: Establish symbiotic relationships with the largest PE firms, laydown pipelines to lend to companies owned by these PE firms and… bada-bing! You’re now able to efficiently deploy billions of dollars.
On the back of this historically unprecedented capital raise and deployment, CIOs and principals of the family offices we work with have been asking us two interrelated questions:
- Has there been an oversupply of credit to middle and upper middle market PE – owned companies?
- How do we make our direct lending portfolio resilient?
Oversupply of capital in credit markets inevitably leads to:
- The compression of credit spreads, which is easily observable, and,
- Weaker lender protections in credit agreements, which requires a close reading of loan documents to measure.
Here are red flags to watch for when selecting and monitoring private credit managers:
To see these red flags, you’ll need access to loan-level information. If your fund manager does not provide access to sufficient loan-level information for you to assess the quality of the loans you own through them, you should be able to request detailed information on specific loans that you (and not the manager) identify.
LENDER PROTECTION METRIC | RED FLAG |
COVENANTS | One or no covenants or / and where the covenants have loose definitions and so are not useful
Useful covenants are those that create a “tabling event” before too much deterioration in value occurs. This allows the lender to “right the ship” by requiring more dollars to be invested, more collateral or /and structural enhancements to the loan. Covenant breaches should be viewed as a feature and not a bug. |
REPAYMENT FLEXIBILITY | Reliance on Payment in Kind (PIK)
Typically used when there is limited current cash flow available to service debt. If structured appropriately, PIK adds convexity but should not be relied on for coupon payments. |
COLLATERAL | Split liens instead of all-asset liens
More generally, greater financial leverage at the loan level is a red flag, particularly at a time when rates are persistently elevated. |
LIABILITY STRUCTURES & INTER-LENDER AGREEMENTS | Many lenders in a uni-tranche loan and /or a multi-tranche capital structure with inter-creditor agreements that are insufficiently specific
This increases the risk of lender-on-lender violence or unexpected subordination. Who holds the pen when writing credit agreements? The lead underwriter? From which loan tranche? The borrower? |
RECOURSE | No or limited personal guarantees from business owners |
RATE FLOORS | Low index (Prime or SOFR) floors on floating rate loans
The more competitive the debt deal, the larger the gap between the existing SOFR rate and the contractual floor, so if SOFR falls, lenders receive less. Again, 1) details matter 2) who holds the pen? |
PRE-PAYMENT PENALTIES | Low or no pre-payment penalties |
LIQUIDITY MONITORING | Less frequent monitoring (e.g., quarterly instead of monthly) |
LOAN MATURITIES | Longer maturities with delayed repayments |
AMORTIZATION | Slow or no amortization
Or amortization only through excess cash flow recaptures. The slower the amortization, the greater the risk that the lender does not recover the principal. |
LEVERAGE AT FUND LEVEL | Leverage exceeding one turn (Sr Debt/ EBITDA)
More than one turn of fund level leverage benefits GPs more than LPs. |
To make your direct lending portfolio more resilient, we recommend adding exposure to managers that invest in loans that have stronger lender protections i.e. no red flags. Yes, it really is that simple.
One way to strengthen lender protections while also materially enhancing all-in yield, is to lend to independent companies (i.e. those not owned by PE firms). Direct lending strategies that focus on loans to PE owned companies offer an opportunity to efficiently deploy large amounts of capital on a consistent basis and are backed by the earnings streams of PE owned companies. In contrast, well managed direct lending strategies that focus on loans to independent companies provide higher all-in yields and stronger lender protections as well as the diversification benefit of being disconnected from PE cycles. (More on that in a future note. For now, we’ll just observe that DPI and MOIC are not converging, even for old vintages, as PE exits have slowed.)
Loans to independent companies aren’t necessarily riskier than loans to PE owned companies; company-specific credit risks can be mitigated by underwriting and loan structuring expertise (Read our article on Risk Mitigation.) These loans typically offer higher all-in yields than loans to PE owned companies and provide exposure to different risks.
So, how should you allocate to direct lending strategies in 2025?
- Ask for – and read – credit agreements to identify red flags. Do not get a false sense of comfort from brand names and AUM measures. In what has been a benign macroeconomic environment in America, we’ve already seen recent reports of lender-on-lender violence, contested lender subordination and other cracks in the middle and upper-middle market sponsor backed space. When the cycle turns, which it inevitably will, you’ll thank yourself for putting in the work and protecting yourself through legally binding contracts.
- Genuinely – not just optically – diversify. Allocating to multiple middle or upper middle market sponsor-backed funds does not provide sufficient diversification. These funds participate in similar deals and often participate in the same deals. Instead, select best-in-class funds from both the PE owned and independent categories.
- Find less crowded segments. This will help you avoid exorbitant congestion pricing (read: tight spreads over SOFR) and, more importantly, the risk of crowd crushes. Identify segments of the direct lending market where, since the supply of capital is less than the demand for capital, the lender holds the pen when finalizing credit agreements.
Funds that lend to independent companies have raised much less capital than those that lend to PE owned companies. This undersupply of capital to independent companies from private credit investors – as well as the weakness in regional banks’ balance sheets due to CRE related stress – has created a target-rich environment for lenders who have experience underwriting loans to independent private companies.
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