Direct lenders’ taste for risk wanes as recession looms - RLPC News

Direct lenders’ taste for risk wanes as recession looms - RLPC News

28-Oct-2022 16:04:05

To view this story on Refinitiv Workspace, click?here

by Prudence Ho

LONDON, Oct 28 (LPC) – Direct lenders are becoming increasingly risk-averse with their investments as recession looms in the European market, cutting down their cheque sizes in club deal underwrites and increasing their cost of debt.

The move has delivered yet another blow to sponsors looking to finance acquisitions. With banks effectively shut for business in terms of new underwrites, direct lenders had become the only game in town to provide debt for buyouts.?

While direct lenders are still open to providing debt, the cheques are now much smaller, meaning that sponsors need to approach more lenders in order to finance a single sizeable acquisition via so-called club deals.

It is not a new phenomenon for direct lenders in Europe to team up to deploy capital, but market players say that such lenders are now much more wary of concentration risk. The move may mean that sponsors are having to scope out new financing routes, including all-in equity deals.

“What is newer is that certain participants in this market that would previously have wanted to do the deal solo and be prepared to consider for a very large cheque are now much more conservative about the size of the ticket that they want to commit to any one name,” said Denise Gibson, a partner and co-head of global leveraged finance at Allen & Overy.?

“If you are looking to raise north of €1bn of debt in the unitranche market, sponsors today are likely to find that the deal needs the support of 10-plus funds, which is not so easy in the current market. More lenders in a club help build a bit more confidence in the deal, and it also avoids concentration risks on any particular name,” said Gibson.

By striking more deals with a lower commitment, it will help diversify direct lenders’ portfolio and limit a potential loss if things go wrong, debt advisers said.

“To perform well in private credit, it is all about protecting the downside. One large credit loss can wipe out the fund’s return. One of the best ways to do that is to diversify the direct lending portfolio, which also reduces the volatility in performance. There is a lot more focus now on diversification given the economic downturn,” said Floris Hovingh, managing director of debt advisory at Perella Weinberg. Strike the balance?

Some direct lenders said the asset class should strike the balance between diversification and asset quality because credit selection has become more important than ever in the current market amid central bank rate rises, spiralling inflation and a looming recession.

“You shouldn’t be buying the market or trying to over diversify for downside protection because you ultimately start to loosen up on credit quality. We are doing between 15 to 25 deals a year with an average deal size of €300m–€500m. Some lenders do 60–100 deals, but you can’t be a beta product in a market environment that is dropping,” said a fund manager at one of the largest credit funds.

The fund manager said most direct lenders are trying to avoid companies with an unclear growth profile and heavy fixed costs. That also explains most direct lenders' focus on non-cyclical sectors such as business services, software and healthcare.?

Pricing hike?

Direct lenders are also asking for higher pricing to get deals done. Margin spreads for direct lending have risen by 50bp–100bp this year, while the total fee including upfront fee and the OID has increased by 25bp–50bp from around 300bp. The all-in yield in some cases can be as high as 10%.

Direct lenders have an advantage over banks, in that their closed-end credit fund structures allows them to lock in their cost of capital, meaning that their funding costs are less affected by market volatility as opposed to banks, which are now asking for all-in yields as high as 19%.

“The underwriting fee for banks now is probably 2% and you’ve got 3%–4% of flex. An OID may be another 5% up front. Then you come to the point at which the client says ‘really?’,” said the leveraged finance banker. "The upfront cost of a [bank] underwrite is almost prohibitive." Asset protection?

To protect themselves in any downturn, direct lenders are also taking advantage of their newly-found bargaining power to tighten terms from covenant to ability to incur additional debt.?

However, some direct lenders still offer covenant-lite loans, which are the norm in a syndicated market. However, they would charge a higher coupon on those deals.

“That's purely just an early warning signal,“ said the fund manager. “What is way more important is can you strip assets? Can you take out cashflow? Can you strip cash? Are you actually senior secured, what is the collateral package? The recovery ratio is much more dependent on those factors rather than a maintenance covenant.”