The Rising Tide Recedes

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.

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. 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.

Strong Underwriting & Structures

LPs need to identify fund managers that have a history of return stability with a focus on consistently diligent underwriting and conservative loan structures. When it comes to structuring, in addition to accounting for things like leverage levels and where a manager sits in the capital stack, ensuring the appropriate lender protections are — and long have been — in place is important.

For example, it is worth evaluating financial covenants over the past five to 10 years; through that more borrower-friendly period, many lenders had been making covenant-lite loans. Our view has never been that a good company doesn’t get covenants, as covenants really have more to do with the borrower-lender relationship. We are only going to lend to companies we view as highly profitable and high performing. Covenants are not an indicator of the quality of a borrower but are instead a tool that gives the lender the ability to reprice risk.

Robust Sourcing & Careful Selection

For managers in this space, the ability to deploy capital on a consistent basis is as important as the sourcing of that capital.

We’ve seen some managers that have proven to be very successful in raising capital in other parts of credit enter the world of direct lending, but they are much less experienced in deploying capital. When it comes to deployment, it is critical to consider whether a direct lender has access to a wide opportunity set so they can avoid potential selection bias.

Origination capabilities matter because they are key to creating a differentiated return…

AdCap looks at between 1,000 and 1,500 transactions in a typical year, selects approximately 9% that pass its criteria to achieve sustainable cash flows, and — following a two- to three-month due diligence process — moves forward with 3% to 4% of that subset.

Consistency Is Key

LPs looking to enter or expand into direct lending can assess potential managers by considering a variety of qualitative and quantitative factors.

First, it’s important to understand the direct lender’s strategy. Is it as attractive today as it was historically? Or has the manager had style drift? The lender’s team – including their historical experience, scale and turnover – is also key to look at.

To evaluate a manager’s origination and underwriting capabilities, investors can ask a range of questions, he noted, including, “How are you sourcing deals? Is your capital formation in line with your deployment pacing? When you think about how you’re producing a return, has that remained consistent?”

When it comes to successfully navigating through the current macro environment…

we believe lenders that have maintained a long-term view — keeping their strategy consistent, origination capabilities robust, underwriting disciplined and loan structures conservative — will be among those best positioned to deliver stable performance and continue gaining market share moving forward.