Could direct lending be the next hot ticket for capital markets?
Could direct lending be the next hot ticket for capital markets?
As businesses look to bolster their operations post-Covid, will they turn to non-traditional lenders – and what opportunities does this present for capital markets practitioners?
With commentary from:
- Chris Skinner - Partner, Head of UK Debt and Capital Advisory, Deloitte
- Paul Simcock - Partner, Alston & Bird
- Mike Hughes - Newly appointed Global Head of Service Lines, Ocorian, formerly JP Morgan, Global Head of Custody
- Sally Gilding - Senior Consultant and Non-Executive Director, Ocorian
Covid-19 delivered a seismic shock to businesses around the world in 2020, forcing many to rethink the way they operated; closing down entire sectors such as aviation and hospitality; and paralysing global supply chains. In many instances, government financial support and forbearance on matters such as taxation and reporting were critical to business survival.
With vaccine rollouts gaining traction and countries slowly opening up again – albeit at different speeds – businesses are examining exactly where they stand and what they do next. For many, this may include restructuring, re-evaluating their operating models and, indeed, refinancing in order to move forward.
For those in the capital markets, this provides opportunities in the private debt space – a market that was already growing pre-pandemic. Worth $575bn at the end of 2016, private debt grew to $848bn at the end of 2020. Perhaps more crucially, it is projected to increase 11.4% annually, to $1.46trn at the end of 2025. Within the US and Europe, the most popular private debt strategy is direct lending.
This is borne out by the findings in our recent global capital markets report ‘Navigating CovExit: searching for value in the debt markets’, which point particularly to a growing interest in direct lending. Of the capital markets professionals surveyed, 87% already have a direct lending strategy, with 57% looking to expand that current strategy. Only1% of respondents have no plans to introduce a direct lending strategy in the next 12 months.
However, as much as the post-Covid corporate landscape may appear perfectly suited to capital markets investors, it won’t be a walk in the park. To get a deeper understanding of the opportunities and challenges in this space, we recently gathered senior capital markets figures together for a webinar entitled ‘Debt in distress: how can private capital practitioners adapt to the challenges ahead?’
The bigger picture
Quite how the broader economic picture will play out in the months ahead is difficult to predict. Exactly how governments will unwind support and move to recoup massive expenditure and lost income – potentially through taxation and new regulation – is still unclear. Alongside this are ongoing trade issues, not least Brexit which has taken place under the cloud of the pandemic. So, just where are the opportunities actually going to lie with regard to insolvencies, restructuring and M&A action?
“We’re living through a fascinating period,” said Chris Skinner, Partner, Head of UK Debt and Capital Advisory, Deloitte. “During the Covid lockdown there were companies that genuinely struggled – in the obvious sectors like travel – but large parts of the economy were supported through various government initiatives and actions. The question is what will happen as those initiatives start to be withdrawn.”
Indeed, Skinner points to his team being busy with new deal flow and new mandates coming through, with new opportunities for debt funds, lenders and underwriters to provide capital. “What I'm much less certain about is how long this is going to last and to what extent we could start seeing an increase in the number of restructurings.”
According to our report, this could be a rich seam for capital markets businesses and there is a sense of expectation. As Sally Gilding, Senior Consultant and Non-Executive Director, Ocorian, who moderated the webinar, highlighted, 92% of those surveyed expect insolvencies and restructurings to present opportunities for them over the next 12 months.
This optimism around direct lending is also set against a backdrop of strong performance in the high-yield space. Yet Paul Simcock, Partner, Alston & Bird, noted how high yield might not be the solution in a stressed or distressed environment.
“It's certainly been the longest bull run that I've seen,” he said. “And despite a correction in 2020, it doesn't look like it’s coming to an end. Yet while the high-yield market is very liquid and booming in Europe and the US, it won’t provide the solution to some of the situations arising post-pandemic.” Which again indicates real opportunity for direct lending.
Deploying the right strategies
So, with the shifts that are likely to take place in the corporate space in the next 12 months, the challenge is exactly how capital markets practitioners execute an effective direct lending strategy in what will be a highly competitive market.
While direct lending tends to create greater exposure in a downward cycle as it typically involves larger tickets to a single name, retrenchment in traditional lending has opened up the doors to capital markets businesses willing to take that risk. “Direct lenders are also more likely to follow an existing investment,” said Simcock. “So, where there is retrenchment there is also opportunity and that’s where I feel direct lenders can fill the space.”
A key advantage for direct lenders is that owing to their size, they can typically be more bespoke in their product. They can be nimbler and work more closely with management where a traditional bank doesn't necessarily have the bandwidth to do this.
Mike Hughes, Global Head of Service Lines, Ocorian, believes this is changing the traditional way business is brought to market. “In a normal market, you would set up your structure, do your capital call and then deploy your capital, but I think we’re seeing that timeline being reduced and not done in an orderly way anymore,” he said.
“I think we’re seeing a new trend of having all three elements of the transaction being completed in parallel to reduce the time to deliver the structure into the market. Capital is available and the Covid pandemic has proved that funds can get access to capital with the right strategies. Direct lenders are willing to lend if they’ve got the right risk profile on a complementary investment business case. I see a massive tightening of the value chain and the life cycle that we’re all used to.”
Simcock, however, stressed that there isn’t a one-size-fits-all strategy, but that he does expect there to be specialisation. “There are now both specialty funds and there are special situations funds – those are the lending strategies that typically benefit from the opportunities as we go into a downward cycle,” he said.
However, it’s possible that capital market lenders may move away from a strategy aimed at a particular type of lending, such as special situations, toward much more of a sector alignment approach. “We already see the polarisation in sector alignment in private equity, which in this sense feels ahead of direct lending,” said Skinner. “It will be interesting to see if there is a similar shift. Will businesses become indifferent to whether they’re lending senior paper, super-senior paper, mezzanine and so on, because LPs are backing their expertise in a given sector as opposed to product alignment?”
State of readiness
All of this presents a rather complex picture, irrespective of the considerable opportunities. In order to take advantage of the market, lenders are going to need the right capabilities in place – and this may mean pivoting from existing strategies or adapting current models.
However, our research revealed that in certain areas, many of those surveyed lacked confidence in their ability to implement direct lending functions. For instance, only 47% felt confident in addressing loss recoveries and 53% in risk assessments. “So we have to ask ourselves, do these institutions have in place sufficiently robust operational, risk and compliance processes to do this at increased scale?” said Gilding. “Or are they inviting unnecessary risk for both themselves and their clients?”
Hughes pointed to certain areas where there is lots of “nasty” administration tasks and functions in direct lending, including consolidation accounting, investor reporting and regulatory compliance, where accurate and timely information has to be given back to investors.
“Cash is the riskiest asset in a capital markets value chain, so you've got to get that right and make sure the controls and processes are in place once you’ve got your structure, once you've got your documentation in place, once you’ve got your legal construct and you know how you’re going to fund it,” he explained.
Critical to all of this is the need for robust data and tech processes. “It’s all about data,” said Hughes. “To be able to drive data models, to capture data at source, to put data into your own portfolio management systems, to be able to provide information back to investors. It’s important that the infrastructure and support model around the transaction is built, but is that really value add for the lender or the fund?”
It’s to be expected that many lenders will turn to third-party providers in order to handle some of the more time-consuming, complex or specialised processes, so that they can focus more on the lending and deal-making itself. This certainly came through in our report where, over the next three years, 92% of respondents expect to outsource their accounting function, while 82% expect the same for cash monitoring and reconciliation and 76% for regulatory reporting.
It is evident that opportunities will arise in direct lending for capital markets businesses as the world emerges from the pandemic. A clearly articulated strategy, which is then well executed can add value and also avoid the potentially expensive pitfalls that litter the post-Covid landscape.
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