The hidden advantages of direct lending

Investors may find value in a fixed income asset that typically benefits from a rising-rate environment.

Amid volatile markets, many investors are looking for stable sources of returns. Direct lending to middle market companies is one option that may suit sophisticated investors, including high-net- worth individuals and institutional investors. “The return profile is attractive, and the asset class has proven to be resilient during periods of economic uncertainty as well,” says Tim Warrick, managing director and alternative credit portfolio manager, at Principal Asset Management^SM.

Warrick notes that direct loans to middle market companies have returned nearly 10% on an annualized basis since 2004, with substantially lower volatility than public market assets. The asset class performance, which is negatively correlated with Treasury performance, typically benefits from periods of rising rates. Though Principal Asset Management forecasts a recession on the horizon as the Federal Reserve continues to remove accommodation through higher policy rates, Warrick believes most companies in the middle market are effectively navigating the impact of historically high inflation and rising interest rates. Since these loans are typically floating rate, the ability of a company to service debt is key to ultimately obtaining the return benefit of higher interest rates. “Despite public market drawdowns and volatility, we’re still realizing very positive returns, with expectations for increased returns as coupons move higher,” he says.

Historical Asset Class Risk/Return
Annualized return and annualized volatility, 2004-2022*

Understanding the middle market direct lending segment

Since the 2008-2009 financial crisis spurred tighter bank lending regulations, direct lending firms have expanded their presence in the market to provide financing solutions for privately held companies, both private equity (PE) backed firms and those that don’t have PE sponsors.

Typically, private equity sponsors work with lenders to support their portfolio companies’ organic growth or further acquisitions—consistent access to lending is a critical part of their strategy. From the lender’s perspective, sponsored transactions typically offer several advantages:

• PE firms often hold additional capital they can deploy to support portfolio companies for growth opportunities, or to provide liquidity during economic downturns.
• PE firms conduct thorough due diligence on their acquisition targets, and many focus on industry verticals in which they have deep operating expertise that direct lenders can utilize during their own due diligence.
• PE sponsors often close several deals each year. That experience means they can both process transactions efficiently and create deal flow at a pace that may be attractive to investors.

Private Equity Middle-Market Dry Powder
$Billions, 2012-2022.

It’s important to note that the direct lending market can be competitive—particularly among larger companies (EBITDA of $50 million+). By contrast, fewer lenders are competing for deal flow in the lower middle market (companies with EBITDA of $5 million to $15 million) and core middle market ($15 million to $50 million), because of the additional origination and underwriting resources required to be successful. As a result, the lenders that have the necessary capabilities to compete in the lower and core middle market can command greater risk premiums, while also realizing better credit structure and lower leverage—providing the potential for better risk-adjusted returns. With lower debt levels and tighter credit terms, these smaller firms can better withstand uncertain economic conditions and higher rates. “These companies are typically resilient in a rising-rate environment,” Warrick says.

Lender specialization and focus

Warrick and his team focus on both sponsored and non-sponsored opportunities in the lower and core middle market—particularly firms in resilient industries that are not heavily exposed to cyclical trends. They prefer to have little exposure to cyclical manufacturing, retail and commodity-oriented industries, where the broad economic environment can significantly impact cash flow. “In these sectors, there is more cash flow volatility driven by variability of revenues and profit margins, as the economy shifts or deteriorates,” he says.

Instead, Warrick’s team concentrates on industries such as health care, business services, consumer nondiscretionary and technology, where companies tend to generate steady revenue streams, strong profit margins and stable cash flow. The team seeks to lend to companies with strong potential for both organic growth, as well as the ability to buy and consolidate similar companies.

Benefits for investors

With today’s uncertain economic environment and the increased likelihood for a recession in the near future, adding direct lending assets to a strategically constructed portfolio could provide multiple benefits. The asset class can provide an opportunity for diversification, since it is not highly correlated with other fixed income assets. Additionally, the floating rate structure of direct loans, along with loans being structured as senior priority debt and secured by assets of the borrower, contributes to the asset class’s relative resiliency, when compared to the broad market.

During the global financial crisis, direct loans experienced default levels about one-third the level of public high-yield bonds, according to Warrick. “Given relatively low expected defaults and reasonably strong recoveries in the event of a default, direct loans often suit investors who are focused on capital preservation,” he says. “Investors also appreciate the high level of income this asset class generates, and given the floating rate nature of the loans, that income will increase with rising interest rates.”