NEW YORK, May 15 (LPC) - Direct lending funds, which are providing capital to middle market companies in increasing amounts, are turning to fellow funds to reduce credit exposure.
Mounting interest in the middle market and intense competition among non-traditional lenders have pushed debt capital providers to speak for larger hold sizes, sometimes ultimately taking down the entire deal to win lead mandates only to offload some of the risk after the fact.
“It’s part of how funds are getting comfortable with writing large checks,” said one market source.
“There is a shadow secondary market,” the source added. “Some of these private credit funds intend to parse out positions to other lenders.”
This dynamic follows from a development in the middle market away from unitranche loans, referring to a single tranche of debt that combines senior and junior capital at a blended cost, often referred to as an agreement among lenders (AAL) structure, toward something called a “single dollar uni”.
Yesterday’s unitranche loans were favored in times of market volatility when sponsors and borrowers needed certainty of execution.
Now that the product is more widely used and the loans are larger in size, the preference is for a single lender to provide the entire loan and then bring in other investors to reduce risk.
“As firms raised bigger funds they prefer to take the whole piece and the market has moved on from the AAL,” said Michael Ewald, a managing director at Bain Capital Credit.
Unlike banks, which arrange loans to distribute among institutional investors, direct lenders are typically buy-and-hold investors, keeping the loans until maturity.
Private equtiy borrowers going down the unitranche route can save on the expenses incurred from rating the loan and avoid the risk of upward price flex during a broader syndication. With funds growing larger, sponsors have more options.
“Regulated banks have been losing share to direct lenders for a while, thanks to higher lender holds. That dynamic has also allowed sponsors to avoid where possible the syndication process, which involves market risk,” said Randy Schwimmer, head of originations at Churchill.
The private credit market continues to grow in size. Funds raised US$96.9bn in 2018, up from US$70.9bn and US$62.6bn in 2017 and 2016, respectively, according to LPC data.
“Between US$50m-US$75m, that is where the line between the funds and banks begin to blur,” Ewald added.
Further, dealing with a direct lender means the terms of the deal are not publicly available and funds place the loan positions with a handful of names.
The underwriter continues to serve as the agent and is open with the borrower about its intention to reduce its position. In some instances, the sponsor will invite a Limited Partner to participate in the debt financing.
“It’s still a people business and it’s important for owners to know who is in the group,” said a second market participant.
To keep up with the rapid growth of the middle market, banks are also tapping into their own strengths to provide complementary services alongside private debt funds to get exposure to the middle market.
Fund expansion means they offer a “cafeteria plan” of options, including a range of instruments beyond the term loan to benefit private equity borrowers, which most banks are so far unable to deliver.
But, banks are able to tap into where direct lenders are at their weakest – funding other debt instruments including revolving credit facilities – due to the fact they have a lower cost of capital and can leverage their much-larger origination networks to provide dealflow for funds. Some are seeking formal partnerships via joint ventures.
“Banks understandably are now looking for an edge in areas where they’ve historically been competitive. One is providing revolving credit capacity. Another is asset-based lending. Finally, some regional banks have more experience in industries such as automotive, natural resources, and energy,” said Schwimmer. (Reporting by David Brooke and Leela Parker Deo. Editing by Michelle Sierra and Lynn Adler.)