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The Merits of Direct Lending

  • Global institutional investors have continued to seek higher yields in a low interest environment which has led to an acceleration of capital flowing to non-bank lending and other private credit strategies.
  • State Street Global Advisors has been an active investor on behalf of its clients in investing in direct lending funds and has helped clients create de novo portfolio allocations to invest in direct lending funds and other private credit strategies.
  • The pandemic has created a more favorable investment environment for direct lenders who are able to deploy fresh capital in this market.
Investment Manager, Private Equity

In just a few years, direct lending has developed from a niche strategy to a major asset class. This remarkable growth has been fueled by strong investor demand and a growing private equity industry. Despite increased market uncertainty as a result of the COVID-19 pandemic, we believe that the current levels of dry powder in private equity will continue to fuel the industry and provide certain direct lenders with ample opportunity to deliver attractive risk-adjusted returns, while helping investors to earn an acceptable yield in a persistently low-interest-rate environment.

At State Street Global Advisors, we’ve actively invested on behalf of our clients in direct lending funds and have helped clients create de novo portfolio allocations to invest in direct lending funds and other private credit strategies. In this piece, we discuss the key merits of direct lending that can make it an appealing asset class for some institutional investors.

As shown below, middle market loans, a core ingredient in most direct lending funds, have generated strong risk-adjusted returns when compared to broadly syndicated loans and high yield bonds. Not only are investors better compensated through both higher origination fees and interest coupons, but they’ve also experienced fewer credit losses. This is because non-bank lenders usually require enhanced due diligence processes, stronger covenant packages and secured lending terms.

Loan Type Comparison

 

Middle Market Loans

Broadly Syndicated Loans

High Yield Loans

Upfront Fees/OID

200–350 bps

100 bps

Infrequent

Coupon

L + 450–750 bps

L + 350–450 bps

3–6%

Rate

Floating

Floating

Fixed

Term/Duration

~3 years

3–5 years

4 years

All-In Yield

7–9%

~5%

~5% index yield

Covenants

Typically, full maintenance-based package negotiated

Generally covenant-lite

Incurrence

Due Diligence

Direct and extensive (3–6 weeks)

Through intermediary/bank (< 1.5 weeks)

Through intermediary/bank (< 1 week)

Liquidity

Limited or None

Medium to High

High

Annual Default Rate

2.4%

2.9%

3.3%

Annual Loss Rate

0.8%

0.9%

2.0%

This data is based on current market observations as of August 2020 and should be used for illustrative purposes only. Several factors could result in substantially different terms, including, but not limited to, the seniority of the loan and risk profile of the borrower. Source: S&P LCD, S&P CreditPro, JPM Morgan Markets, Bloomberg. Annual loss rate using middle-market loans’ 21-year average annual default rate of 2.4% (1999-LTM Aug. 2020, obtained from S&P LCD) and long-term recovery rate (1990-LTM Aug. 2020) of 66% (source: JPM, Moody’s). (2.4% x (1 – 66%)) = 0.8% Annual loss rate estimated using broadly syndicated loans’ 21-year average annual default rate of 2.9% (1999-LTM Aug. 2020, obtained from S&P LCD) and long-term recovery rate (1990-LTM Aug. 2020) of 66% (source: JPM, Moody’s). (2.9% x (1 – 66%)) = 0.9% Annual loss rate estimated using High Yield bonds’ 1999–LTM Aug. 2020 avg annual default rate of 2.0% (obtained from JP Morgan) and long-term recovery rate (1995-LTM Aug. 2020) of 40% (source: JPM, Moody’s). (3.3% x (1 – 40%)) = 3.3%.

Middle market loans have also been less susceptible to market swings and volatility. They’re generally held by a sole lender or a small group of lenders and rarely trade in the secondary market. As a result, carrying values are updated only quarterly, and although valuations fluctuate, the predetermined intention for most managers is to hold the loans until maturity or repayment; the loans are usually repaid at par well before their maturity date.

The floating rate mechanism present in most middle market loans is another factor that helps dampen volatility. Since coupons are generally tied to a risk-free rate such as LIBOR, the risk of rising rates is largely mitigated. If the loans are structured with a LIBOR floor, investors can also better preserve their interest coupons in a falling rate environment, like the one we’re experiencing today.

In a fund structure, managers also seek to build highly diversified portfolios. Fund vehicles with a direct lending strategy that are operating at scale generally include 40 to 60 loans which are well-diversified by industry, region and sponsor. When managers reach certain diversification thresholds in the portfolio construction phase, they may also elect to secure additional capital from a lending facility, which can be drawn to originate additional loans — essentially creating a margin that helps boost fund level returns for limited partners willing to accept this risk.

Compared to private equity, another appealing quality of direct lending within a fund structure, is the absence of a “J-curve” given management fees are typically charged on invested capital rather than committed capital, and any cash interest received from the underlying loans is distributed to limited partners as current income.

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Looking Forward

Although there is an elevated level of uncertainty as a result of COVID-19, making it more difficult to underwrite new deals, the pandemic has also created a more favorable investment environment for direct lenders who are able to deploy fresh capital in this market. When compared to just a few months ago, new deals are being financed with more equity, pricing is more attractive to the tune of 50–100 basis points or more for loans with similar risk attributes and lenders are securing full covenants (as of this writing). We expect this trend to continue given the current environment


About State Street Global Advisors

For four decades, State Street Global Advisors has served the world’s governments, institutions and financial advisors. With a rigorous, risk-aware approach built on research, analysis and market-tested experience, we build from a breadth of active and index strategies to create costeffective solutions. As stewards, we help portfolio companies see that what is fair for people and sustainable for the planet can deliver long-term performance. And, as pioneers in index, ETF, and ESG investing, we are always inventing new ways to invest. As a result, we have become the world’s third-largest asset manager with US $3.05 trillion* under our care.


*  This figure is presented as of June 30, 2020 and includes approximately $69.52 billion of assets with respect to SPDR products for which State Street Global Advisors Funds Distributors, LLC (SSGA FD) acts solely as the marketing agent. SSGA FD and State Street Global Advisors are affiliated.