Global Head of Capital Markets, Alan Booth draws on our survey of capital markets decision makers from across Europe, North America, Asia and Africa, to shed light on why a staggering 87% of firms surveyed have a direct lending strategy in place and explain how these firms can overcome operational challenges by optimising their approach to administration.
Our research found that the majority (57%) of capital market investors have an existing direct lending strategy which they are looking to expand, while 30% have a strategy that they are in the process of executing.
These findings add substance to the narrative of banks being supplanted by alternative lenders as funders for midsized businesses, a trend that has picked up significant momentum since the global financial crisis of 2007/8. For example, going into 2021 non-bank lenders had a 74% market share of the European mid-market direct lending space.
As government subsidies and support schemes pull away, banks, constrained by regulation, commercial appetite and their focus on sustaining profitability in a low interest rate environment, are unlikely to extend credit facilities to midsized businesses. This is going to leave a real need for capital and is likely to be felt most acutely in the hardest-hit sectors.
The potential opportunities created by this void are an attractive proposition for private capital funds. This appetite can be clearly seen in the US, where direct lending was the most popular strategy in terms of funds closed in 2020 (43). Similarly, in Europe, direct lending accounted for 56% of all funds closed in 2020.
On a global level, direct lending has had a bumper decade, with total assets under management of private debt funds increasing from $275 billion in 2009 to $887 billion in 2020. A major contributing factor to these inflows has been the sustained low interest rate environment. It has pushed institutional investors such as insurance companies, pension and sovereign wealth funds into the direct lending space as they seek stronger returns than those available in the public markets. In return, investors have benefited from attractive returns and outperformance of other income-orientated strategies on a risk-adjusted basis.
The right capabilities are needed to capitalise on opportunities
Private capital funds wishing to offer direct lending strategies in the distressed debt space may face several challenges. As much as they might anticipate increasing opportunities, they will require the right capabilities to capitalise on them.
For some of them it will involve major strategic shifts that may create hurdles. For example, funds pivoting from a private equity or real estate focus towards direct lending may have challenges in adapting their infrastructure to meet their information and decision-making needs. These constraints potentially limit the scalability of business models, resulting in sub-optimal data management and workflow processing. In turn, this would raise administration and compliance risks that might damage investor confidence.
Fund managers might be able to manage loan books that are performing well but how will they fare if underperformance sets in? As pandemic-driven government support schemes are withdrawn, it is widely accepted that there will be a significantly higher risk of defaults. The question is then whether these fund managers have the experience of previous credit cycles to weather the potential storm?
Loss recovery is a major challenge
Given this, it is perhaps unsurprising that our respondents express least confidence in their capabilities to address loss recoveries (47%), risk assessment (53%), statement production (54%) and covenant monitoring (57%). They are most confident in taking security (90%), efficient data processing and deal booking (72%), and know your customer requirements (63%).
Interestingly, respondents from younger firms (operational for less than five years) only had 25% confidence in their businesses' direct lending capabilities when considering loss recoveries, reviewing and signing loan documentation, efficient deal booking and data processing. This could point to a lack of experience or bandwidth of administering and executing recoveries under challenging conditions. In this scenario, lenders, sponsors and managements must juggle the commercial and operational challenges of the crisis faced by borrowers, whilst meeting investors' appetite for data and outlook updates.
Strategic success will rely on effective operational execution
Whilst the opportunities for direct lending may be there, private capital funds need sufficient infrastructure and operational capacity in order to capitalise on them effectively. Private capital funds - particularly mid-market players with fewer resources – will need personnel with experience in direct lending through the whole credit life cycle so they can identify, understand and address the risks in their operational systems and processes. From managing covenants to collecting payments, the right expertise is vital in reducing risk, ensuring compliance, and increasing operational efficiency.
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