Institutional investors have continued to flock to direct lending for diversification and return throughout the post-GFC era. The current market environment, however, is starting to highlight that a rising tide does not necessarily lift all boats. Against this backdrop, many have come to recognize that managing through today’s complex environment requires the hand of an experienced direct lender that can consistently — across market cycles — maintain robust origination, disciplined underwriting and conservative capital structures in order to deliver the return stability expected from the asset class.
When it comes to what has been attracting investors to direct lending, macro dynamics to date have generally served the asset class well. “As the space has grown over the past 10-plus years, we’ve seen greater awareness that the appeal of direct lending isn’t just about the prospect of higher returns — it’s higher returns coupled with characteristics of the asset class that we believe help minimize volatility and support the stability of those returns over time,” said Trevor Clark, founder and managing partner of TPG Angelo Gordon’s middle market direct lending business, TPG Twin Brook Capital Partners. “Not only is it a non-mark-to-market asset that is third-party reviewed, it’s also a floating-rate asset class. As interest rates have moved up, direct lending has benefitted while other parts of the fixed-income spectrum have suffered.”
That said, not all direct lenders are the same, and — for some — achieving the steady performance that has historically been characteristic of the asset class may be becoming easier said than done. The credit market had been relatively benign over much of the last decade, thus “a lot of different managers — regardless of their experience, consistency or discipline — were printing returns, which had made it more challenging to gauge differentiation,” Clark pointed out. “But in today’s marketplace, you’re starting to see greater dispersion in default rates and returns. Not every market participant is going to be able to produce the same type of return — not only from an absolute level, but also from a durability standpoint.”
“In this context, we’re seeing investors renew their focus on underwriting processes, loan structuring, and the experience and infrastructure that teams already have in place. We believe all these factors will drive manager differentiation in the direct lending space over the coming years,” Clark said.
Market and industry dynamics have shifted, with many borrowers feeling the pressure of persistently high interest rates that increase their cost of financing. “The looser underwriting standards and more aggressive capital structures that some lenders applied over the past several years may come back to haunt them,” Clark said. “Given the stress that’s being brought to bear on companies today, you can no longer get away with a looser view. Whether it’s in the form of lending to companies that don’t have the required stability of cash flows, increasing leverage without the appropriate interest coverage, or a lack of lender protections — all of those things are going to undermine a manager’s portfolio, and eventually losses can occur.”