Exhibit 4: Average covenant headroom for first-lien Direct Lending deals
Source: StepStone Private Debt Internal Database, based on more than 8,000 US and EU first-lien loans
Exhibit 5: Average EBITDA adjustments for first-lien Direct Lending deals
Source: StepStone Private Debt Internal Database, based on more than 8,000 US and EU first-lien loans
During economic downturns, banks often have little or no ability to underwrite syndicated leveraged loans causing a liquidity shortage for middle-market companies. Direct lenders with ample dry powder to invest are well-placed to fill the gap left by banks. Due to the reduced competition, lenders should be able to negotiate more lender-friendly terms, such as higher pricing, lower leverage, more covenants, less covenant headroom or EBITDA adjustment. Although the consequences from the COVID-19 crisis are still uncertain, some first observations can already be drawn. After a massive reduction of deal flow, one could observe more lender-friendly terms in the first post-crisis transactions. StepStone observed a pickup in pricing combined with lower leverage level, price multiple, covenant headroom and EBITDA adjustment.
2.2.5 Outlook
The rise of corporate direct lending may have coincided with perhaps the longest economic recovery ever, but this success is here to last. Even though it is too early to gauge the consequences of the COVID-19 outbreak on direct lending, we believe the asset class will continue to capture market share from banks for several reasons:
Continued bank disintermediation: Traditional banks appear likely to continue focusing on large corporations, shying away from borrowers at the lower end of the market. This allows direct lenders to remain focused on small and middle markets, prolonging the trend of banking disintermediation.
Direct lenders’ ability to execute larger transactions: As GPs raise more capital, they will eventually compete with the leveraged loan market for larger deals. In Europe, we have already seen some GPs pursue billion-euro transactions.
Sponsor preferences for direct lenders: As previously stated, direct lenders can offer more flexible terms than traditional lenders. Private equity GPs have taken note and increasingly turn to credit managers to finance acquisition bids. Direct lenders also know borrowers more thoroughly than banks do, gaining greater insight into each borrower’s idiosyncrasies as a result. In this way, direct lenders are better able to help private equity GPs recapitalize their portfolio companies if needed.
Non-dilutive growth capital: Family- and founder-run businesses are gradually developing an appreciation for private debt. They used to view direct lending as just a more expensive lending solution but have come to regard it as a non-dilutive source of capital to increase valuation to an exit.
Migration of talent: During private debt’s rapid maturation, there has been a gradual shift of talent from banks to debt funds. We believe this trend will continue, further undermining banks’ ability to compete for market share.
2.3.1 Overview
Opportunistic lending covers a broad spectrum of credit strategies. A simplified approach to visualizing this market segment would be to compare it with more mainstream strategies and products, as shown in this section.
Exhibit 6: Opportunistic Lending
Currently there is a market opportunity in the financing gap for borrowers seeking funding at a cost of capital of 10 to 15%. An increasing number of private debt funds are raising capital to provide a solution for these borrowers. The COVID-19 pandemic has created a favourable environment for opportunistic lenders as many borrowers are expected to go through challenging times. For managers with sufficient dry powder, short-term market volatility may also present interesting opportunities.
The sub-strategies include:
direct lending into complex situations such as growth capital, refinancing of overleveraged balance sheets, time-sensitive events, shareholder restructuring, challenging sectors and hung syndications inter alia;
acquiring loans at a discount to par sourced both privately and on public markets (secondary purchase).
2.3.2 Market Growth
For direct lending into complex situations, transactions are sourced directly from middle-market companies both in the US and in Europe. We anticipate that a certain percentage of middle-market firms will experience a complex situation requiring an opportunistic credit solution. Under normal circumstances, an estimated 5% of middle-market borrowers will require customized opportunistic financing, leading to a market size of more than USD 80 billion, potentially increasing during an economic downturn.
For secondary situations, market opportunities arise in the syndicated loan market. Based on a market size of USD 1.61 trillion,[6] and assuming that on average 22% of loans trade below 80% of par during a recession, as demonstrated in the GFC, we estimate the market for opportunistic lending to be approximately USD 350 billion. To profit from secondary opportunities, managers must have sufficient capital at hand and be able to act swiftly.
There are several drivers supporting the growth of the opportunistic lending market:
Borrower experience of private debt: Given the increasing prevalence of direct lending in the middle market, borrowers (in certain complex situations) are gaining a more detailed understanding of non-bank financing and becoming more open to opportunistic lending, especially given the lack of other options.
Post-COVID-19 environment: The borrower-friendly environment prevailing before the COVID-19 outbreak pushed leverage to pre-GFC levels; most leveraged loans were covenant lite. The increased uncertainty about future economic conditions as well as liquidity concerns could trigger further downgrades and exacerbate outflows of capital, particularly from CLO investors, in the leveraged loan market. This would lead to some value dislocation from credit fundamentals and present investment opportunities on the secondary market for selective managers.
Bank deleveraging balance sheets: Within Europe, regulatory reforms through Basel III have increased capital requirements for banks. As sub-investment-grade corporate risk attracts the highest capital charges, banks are motivated sellers for these assets to meet the capital requirements. In 2016, European banks held an estimated EUR 700 billion in non-core corporate loans.[7] This represents a significant source of potential deals for opportunistic lenders.
2.3.3 Risk-adjusted Returns
Below is a simplified method to understand the return drivers for different transaction types within the opportunistic lending segment in 2020.
Table 1: Return Drivers by Transaction Type
| Transaction Type | Upfront Fees/ Discount to Par |