Direct lending’s evolving role in the loan markets
Article 3 minute read

Direct lending’s evolving role in the loan markets

12 July 2018

As banks have reduced credit lines and shrunk their balance sheets, funds with money to deploy have been looking for new opportunities which will generate returns. Direct lending has emerged as a solution for funds and more broadly, for the loan markets.

The US is the most mature direct lending market, but Europe is catching up and at TMF Group we’re seeing growing interest in Asia Pacific, Latin America and other emerging economies. It’s becoming a global phenomenon, with the Alternative Credit Council (ACC) stating that it expects the global direct lending market to pass US$1tn by 2020.

New regulatory considerations, such as Basel IV, will help drive this growth as the banks further retrench and reduce long term credit exposures. Direct lenders also potentially have the appetite to support companies with higher leverage, as they aren’t subject to the same capital requirement guidelines as banks. This should mean more attractive returns for investors.

The direct lending market offers an attractive proposition, but those wishing to get involved should make sure that they fully understand this nascent sector and the forces that shape it.

Apply a credit committee approach to investments

Competition in the direct lending market has increased rapidly, resulting in a wider range of more complex deals being made. As more funds get involved in direct lending, looking for larger ticket sizes, there is a danger of lenders compromising on credit quality.

Funds are often applying an equity investment approval process to something that really requires a credit committee. They should be doing a deeper dive, looking for potential risks and assessing the credit standing and ability of prospective borrowers to repay the debt. There are questions around how this will translate to risk appetite and exposure as the direct lending market continues to mature.

It’s important to be cognisant of the sub-prime market. Don’t just chase yield – make sure that you understand the credit. We hear from pension funds, for example, that are looking to the loan market in search of higher yield. Hedge funds and banks investing in sub-prime mortgages was the trigger for the 2008 financial crisis – it’s important to work with the right partners and to carry out due diligence.

Be mindful of interest rate rises

The conditions created by the perfect storm that pulled asset managers and other institutions in to direct lending are beginning to change, with rising interest rates on the horizon.

The full impact that rising interest rates will have depends on the reasons behind the loan. Those opportunistic loans, which institutional capital is attracted to as they arise, may decline. In a rising rate environment, companies want to keep the cost of capital low and only borrow when they absolutely must borrow.

However, we will likely see an increase in direct lending investments linked to specific strategic projects, such as M&A activity and refinancing. Many of those who have entered the direct lending market in recent years have spent considerably on the required infrastructure and talent to drive these activities. Rather than pull back, they are just likely to become more targeted.

Funds are steadily building up loan portfolios. What started out as opportunistic investments for many has turned in to significant portfolios, often featuring both syndicated and bilateral loans, that need to be managed carefully.

Remember the secondary market

There is becoming more of a focus on the secondary loan market as direct lending grows. A recent development in the US capital markets, for example, is the significant growth in the trading of syndicated loans.

The direct lending dynamic creates an interesting challenge. When it comes to transferring loans, banks and other traditional lenders will be interacting with direct lenders who often haven’t been on-boarded in terms of know your customer (KYC). A lot of agents may not want to put a new fund through KYC, and this can cause a real obstacle in terms of liquidity.

Talk to us

TMF Group has been heavily involved in the direct lending space from the outset.

Our services are multi-faceted. We can provide support to a typical syndicated loan, through the provision of truly independent, facility agent and security agent services across a number of markets in our 83-country footprint.

We can also support direct lenders who may be interested in appointing a third party to manage their loan book. We have invested in systems to support agency and servicing, and we are unique as an independent provider of these services, in also having a fund services offering.

Make an enquiry with us today.

Learn how we help our global clients to maintain focus on their core.

Written by

Paul Wilden

Head of Capital Markets Services

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