Direct Lending

Macro backdrop

Over the past year and a half, we have seen the fastest monetary policy tightening cycle since the 1980s, which traditionally can drive stress for floating rate asset classes like direct lending. Aside from rising interest rates, high inflation levels and energy crises in specific segments of the market have driven investor concerns in allocating to risk or illiquid assets.

Our view is that direct lending has held up well historically as underlying companies across core, defensive sectors have been able to affirm pricing power to pass on rising costs to end consumers. Though cyclical companies and names closely tied to the performance of the regional banking industry will face headwinds of a market downturn, investments concentrated in non-cyclical businesses structured with protections and covenants should prove resilient over the long run.

Fundamentals & market dynamics

The supply growth for direct lending is supported from the broader growth of private financing. Though there had been a slowdown of deals coming to the market through the end of last year, mainly driven by supply chain issues coming out of COVID, global macroeconomic concerns, and industry considerations and valuations, the market continues to see positive secular growth trends, further exacerbated by new deal flow stemming from pockets where the bank market has stepped back, notably in the commercial real estate market.

Aside from the recent market stresses, increased regulation is putting pressure on banks and further driving the shift from bank financing to non-bank financing. In Germany, over a five-year period, private credit has risen from 16% to 70% of the composition of middle market financing, though in other countries like the Nordics this shift has taken longer to play out from banks that have been well capitalized. The trend also persists in the U.S., driving more large cap issuance and deals with larger leverage to the private credit market from underlying names that can support direct transactions. With capital thresholds increasing, banks will have to compensate for higher charges for protecting bank deposits, likely resulting in additional shifts towards non-bank lending.

We see issuers as inclined to have options for private financing, especially in times of dislocation where pricing could be uncertain, and execution could be challenged irrespective of the underlying credit. The growing demand from institutional investors has been well absorbed by additional deal flow of existing companies that are generally healthy and growing, refinancing at similar multiples, as well as mature companies that traditionally have not been private credit users coming to market at lower valuations.

Q2 has seen a pickup in supply as more private equity money is being put to work, with an estimated $200 billion of dry powder available across private credit strategies. The relationship between private equity and private credit continues to be symbiotic. Our view is that selective relationships across PE sponsors will be important for accessing capital markets and pricing.

Expect future consolidation of managers in the direct lending space as the asset class continues to grow. Scale will be needed to manage the complexity of the asset class across origination requirements, execution, and restructuring capabilities. Larger players with the infrastructure in place to grow their platforms should benefit from this consolidation.

Opportunities & forward outlook

Transaction activity in the U.S. market has stemmed mainly from refinancings, which we believe is an encouraging sign and validation of building a portfolio made up of more defensive companies. We view the secular shift of private credit being the more preferred, if not go-to market for most middle market names will benefit investors over the long-term. Healthy companies remain focused on staying defensive by injecting cash into their businesses, cutting costs, and reducing discretionary spending in an effort to extend the runway for a period where higher rates are expected for longer.

Across the European market, opportunities are arising across defensive businesses in healthcare, software and technology, and professional services, sectors which have comprised a majority of the M&A and private activity in the region over the last years. Middle market lending could provide investors more opportunity relative to large cap lending, as deals in the large cap space are often a club with many other lenders. This makes it more difficult to actively engage with companies to potentially improve decision-making and loan structuring, reinforcing our view that strong covenant protections, documents, and other rights are vital to protect end investors.

Private credit illiquidity premia should continue to help amplify income, but more importantly, we believe a greater ability to drive deal structures and covenants will continue leading to stronger protections, lower defaults, and higher recoveries versus public market equivalents.

The current market stresses will be the first for what is a relatively new asset class. Our view is managers that have relied on cyclical sectors will begin to feel pain, though losses will take a long time to crystalize, and it will be a few years before we begin to see the dispersion of performance across managers. More recent fund vintages that have been more structurally protective and defensive should outperform older vintages through the cycle.

1Q2023 generated a 25bp realized loss rate for the Cliffwater Direct Lending Index (CDLI), the highest in over two years. That said, on a trailing 12-month basis, the realized loss rate of the CDLI is still well below our loss estimates for the USD HY and USD leveraged loan indices. This is consistent with our expectation given the structural protections inherent in private credit, and we expect this pattern to persist, even as we look for default rates to rise moderately across public and private credit. The performance of the CDLI lagged the broader USD HY and USD leveraged loan markets in 1Q2023, a rare underperformance, as the USD HY market benefited from a rally in rates and the USD leveraged loan market benefited from a favorable supply-demand technical. We would expect performance for direct lending to mean revert relative to these sectors.