Will the direct lenders turn out to be wolves in sheep’s clothing?

Direct lenders and debt funds have historically presented themselves as more suitable partners for businesses than banks, bondholders or other institutional lenders. When the going gets tough, they may be quicker to walk away from covenants and offer new money than a less concentrated group of creditors. But it also puts them in pole position to take the keys to a business if something goes wrong, which we might see happening this year.

Concentrated creditors groups have their advantages. As direct lenders began to engage in middle market lending in Europe, they were keen to publicize these benefits, especially with sponsors.

Direct lenders argue, and rightly so, that they can be quicker to make financing commitments. They are smaller and less bureaucratic than the banks; and with fewer counterparties involved, when speed is of the essence, it is best to deal with a single creditor.

They can also boast of offering flexibility. Highly leveraged or complex transactions, loans to non-traditional sectors, and transactions with unusual structures are all ideal areas for direct lenders, as it can be difficult for banks to break up and syndicate these types of transactions. risks.

Then there is the sense of partnership that some funds claim to offer. They can be flexible about targeted acquisitions, exclusions, dividends, and other corporate actions in ways that most institutional lenders cannot.

They expect good access to management information, but can use this better understanding of the business to further adapt to new approaches to the business. They might even be happy to put in fresh money, to help a sponsor complete their investment thesis.

In public markets, lenders and investors have little particular reason to trust management teams or sponsors. Access to management is scarce and information flows are tightly controlled. Quarterly report analysis becomes a contest between analysts seeking to uncover the truth and management seeking to obscure it.

But direct lenders take concentrated positions. A fund can give maybe 10 loans, rather than the hundreds that end up in a CLO. They expect to dig deeper into each business and have an intimate understanding of their business drivers, along with better insight and access to leadership. After all, if you’re the only creditor in a business, all you have to do is pick up the phone.

Manage the business

So far, in the Covid-19 crisis, it has worked mostly well. But the pandemic is not yet over.

Direct lenders, as well as their public market counterparts, have been largely willing to forgo leveraging breaches caused by the pandemic, often in exchange for minimum liquidity commitments. The funds may charge a fee of 50-150bp for the waiver, or a progressive drawdown on the margin as the business becomes more indebted.

Few institutional lenders, whether banks, CLOs or loan funds, have had much appetite to take the keys to struggling sponsors.

There have been a handful of cases involving the more difficult companies – Swissport or Europcar, for example – where loans and bonds ended up in the hands of struggling debt specialists able to transform their positions in debt structures. share capital.

But aggressive enforcement is not in the playbook for most parity lenders. They don’t have the skills, the spare time, or the appetite to become business owners rather than the financial ones. Unless they sell off their positions in the troubled debt market, assuming transfer restrictions allow, they often lack coordination to complete restructuring on the most favorable terms.

This is not always true for direct lenders. A number of the larger private lenders sit on larger alternative asset managers, often with substantial private stakes and distressed debt interests. They have the skills and the appetite to own businesses on the cheap.

The very model of partnership that gives direct lenders a deep insight into a business also gives these lenders a clear idea of ​​the opportunities available to enforce security and take over a struggling business. They understand the strengths and weaknesses of existing management and strategies, the competitive landscape, risks and opportunities.

Their facility agreements also often have teeth that are not present in public markets. Maintenance clauses are generally present, warranty packages are more solid and security more applicable. The flip side of the informal flexibility that direct lenders are willing to give to sponsors is a more restrictive formal document, than an increasingly lax “B” term loan or high yield bond documentation.

If direct lenders want to play hard in restructuring, taking over a struggling business, or extracting value, they usually just have to negotiate with themselves. They are not always the only lender in a business, but they are likely to be part of a small club, which allows them to skip the delicate phase of forming creditors committees, finding advisors and to align interests. Again, a few phone calls will suffice.

Put it all together and some direct lenders may end up swallowing the companies they have loaned as partners. That’s not necessarily a bad thing – debt-for-equity swapping is a mainstay of corporate restructuring for a reason – but it might not fit well with sponsors and other owners who bought the hype from direct loans. But for direct lenders, who have a choice between low margin gains and fees for waivers of covenants or taking over the business and selling it four or five years later, the latter might be the choice. more lucrative.

A safeguard, for some, will be a fund’s long-term reputation. Direct lenders are still in urgent need of new transactions and compete with public markets, which have proven to be the most accommodating since being backed by central banks, and banks, which are increasingly desperate to cut back. loan budgets.

Funds that earn a reputation for being ready to trigger security for businesses grappling with the impact of the pandemic will struggle to find attractive deals in the future.

But with the deployment of Covid-19 vaccines and the end of blockages in sight, the temptation may still prove to be too great in some cases, and sponsors could end up regretting the day they raised funds from direct lenders and helped to “disintermediate” the banking system.