What is direct lending, and why should you care?

The Benefits of Direct Lending — How Investors Can Take Advantage of the Increased Interest in Private Debt

Key Points:

1. The direct lending market is growing in Australia because more small-and-middle-size companies rely on private debt to fund growth as traditional lenders favour larger corporations.

2. Middle-size companies use direct lending because they are too large to qualify for small business loans and too small for financing aimed at established corporations.

3. Advantages like predictable returns, above-average yields, and structural flexibility, combined with lender protections, make direct lending an attractive choice for investors.

4. The demand for direct loans has created a large pool of options for private lenders in Australia. As more small companies enter the middle market, the need should increase further.

The COVID-19 era was defined by volatility for investors. The post-pandemic environment brought conflict, inflation, and more uncertainty. As stock markets fluctuate, debt is an attractive option for more predictable returns. However, the need to use banks, private equity funds, or credit brokers can limit returns for non-institutional lenders. Direct lending reduces the need of these go-betweens, leading to a potential for better returns.

Other advantages of direct lending as described below can further enhance profitability.

The Middle Market Is Hungry for Direct Lending Opportunities

Direct lending is especially attractive for companies that are too large to qualify for financing aimed at small businesses but too small for institutional lenders, who prefer established corporate borrowers.

Who are the borrowers in this lending gap?

The Australian Taxation Office defines middle-size businesses as those that had a turnover of between $10 million and $250 million, though 80% were in the $10 million to $50 million range. Meanwhile, the Australian Bureau of Statistics defines middle-size companies as those employing more than 20 but less than 200 people.

A Gap in Traditional Lending

Institutional lenders have recently diverted from companies of smaller size. Concerns for these traditional lenders could include a lack of credit history, worries about non-traditional sources of revenue, or a shortage of revenue data complicating the underwriting process.

The reduction of capital in the middle market creates an impediment to growth and investment, limiting development opportunities.

Advantages for Borrowers

These middle-size firms can find a bespoke solution to their borrowing needs with direct lending. In addition to availability, direct lending offers flexibility to borrowers. Loans can be structured to meet their needs and fit within their debt hierarchy. Lenders typically have their own underwriting process, and can offer more flexibility and add terms designed to reduce risks without creating adverse conditions for the borrower.

Loan Types

These private debt loans usually come in the form of a senior loan, which the lender needs to repay before settling other debts. These win-win loans bring lower interest rates to borrowers and less risk to lenders. However, borrowers with existing obligations and lenders seeking higher yields can opt for a second-lien loan, which is still high in the debt hierarchy but subordinate to senior loans.

Both these loan forms are typically collateralised, limiting the risk of default further.

Subordinate loans may or may not be secured by collateral, but they are much lower on the repayment priority scale.

Direct lenders can also get creative and use unitranche debt to combine different loan categories into a single loan. The hybrid structures put senior and subordinate debt into one loan. The yield for lenders is typically a blend of the interest rates for the different components. The goal of unitranche debt is to create predictability, with both borrowers and lenders relying on one payment.

How Investors Can Benefit from Direct Lending to Middle-Size Firms

There are use cases for direct lending for middle-size companies. Investors reading this are likely wondering, "What's in it for me?"

The benefits for direct lending investors are wide-ranging.

Attractive Returns

There are two factors that make direct lending attractive to investors seeking to maximise returns. First, these loans are illiquid, qualifying investors for a yield premium. This means senior direct loans tend to have higher yields than comparable fixed-income assets available on public markets. Because of the incrementally higher risk, second-lien loans have a slightly higher yield.

The second advantage is that the loans typically have a floating rate. The rate adjusts based on a pre-defined benchmark, such as the Bank Bill Swap Rate (BBSW) or cash rate. This feature eliminates the interest risk often associated with fixed-rate debt. For investors, having the floating rate also means they will not miss out on better returns while their capital is tied up in the direct loan.

To provide protection against a decrease in the underlying base rate, direct loans may have a minimum base rate feature to set a floor on the all-in interest rate.

A Tool for Diversification

Direct lending could be used for hedging against drops in the stock or bond markets. This is because this variety of private debt does not typically have a strong correlation to traditional stock markets.

The lack of correlation extends to other fixed-income investments. The floating-rate nature of the loans helps to hedge against changes in interest rates. In addition, the shorter terms (most direct loans reach maturity in three to five years) may provide duration diversification benefits.

Lender Protections

The loans are often secured by assets or equity, which means the investor will likely get some form of compensation in the event of a default. However, because these loans usually sit very high in a company's debt structure (senior or second-lien loans), a total default is less of a risk.

Furthermore, lenders can add details, such as a call protection clause, to eliminate the risk of early payment, which could limit earnings from interest payments.

Risks Associated with Direct Lending and How to Deal with Them

Though direct lending brings the potential for high yield and offers investor protection, there are some risks to be aware of.

Credit Risk

Direct lending activities still come with credit risk. Default is always possible when extending credit. Like any type of investment, the key to limiting credit risk is understanding the counterparty and assessing their business risks, which could include issues like product lifespan, elasticity of demand, input costs and availability, experience level of management, competitive landscape and industry dynamics.

In addition, protections such as security or collateralisation and conditions that trigger during different stages of default can help reduce credit risk. Since private debt offers more flexibility, such protections to lenders are possible.

Illiquidity

In most cases, direct loans, like most forms of private debt, are often held until maturity or the completion of the term. This means they are usually illiquid. As mentioned above, the higher yield compensates investors for this characteristic. It is usually also difficult to trade loans or transfer ownership to other lenders. As a result, the capital is generally tied up for the duration of the loan. In addition to limiting the ability to exit if the loan becomes unprofitable, a secondary market is generally illiquid or not available for investors to quickly sell the debt to redeploy capital elsewhere.

The Future of Direct Lending to Middle-Size Companies

In the short term, experts expect yields to remain high for direct lending driven by better loan pricing and structuring. At the same time, the pool of middle-size companies is expanding. The fastest segment of growth in Australia in 2021-2022 was observed in companies with $5 million to $10 million in turnover (14.3% increase compared to the prior year).

Thanks to these factors, opportunities are available for investors who want to access the advantages of direct lending.