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QuickTake Q&A

What's Direct Lending? Bank Loans Without a Bank

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What’s direct lending? Old-fashioned bank lending, just without the bank. As tougher regulations have reshaped the post-financial crisis landscape, traditional banks have cut back on business lending. That’s created an opportunity for a growing group of asset managers who are making loans to mid-market companies. For investors, it’s an increasingly popular answer to low-yield woes. Some companies big enough to tap the syndicated debt market are choosing direct lending instead. The question for regulators is whether the market can sustain such growth without making a mess.

1. How does direct lending work?

It starts with asset managers -- initially, mostly hedge funds and private-equity funds, but now other types of investors as well, including insurance firms -- raising pools of money from investors interested in debt. The managers field pitches from debt advisers with investment opportunities, or private-equity funds looking to finance acquisitions. The direct-lending fund does its own research before deploying its money. Direct lenders tend to hold onto the loans long-term, sometimes offering growth support to the company and entering into multiple funding rounds, although some funds do sell a small proportion of their debt.

2. Who borrows from them?

Typically, mid-market-sized businesses that banks are no longer interested in lending to. Their need for credit and lack of good alternatives means direct lenders are able to extract higher interest rates -- generally speaking, at least 2 percentage points more than what comparable businesses must pay to borrow from banks or the syndicated debt market.

3. Why is direct lending in the news?

Direct lenders are accumulating more money and pursuing different types of deals. About $13.3 billion was raised globally in the first quarter of 2017, more than half the total for 2016, according to Deloitte. The U.S. is the biggest center for direct lending, with a 61 percent share of the market. As of June 2016, private credit providers had $595 billion in assets under management, according to research firm Preqin.

4. How are the deals changing?

Some European direct lenders are teaming up to chase larger deals. They’re also targeting more high-profile firms. Heckler and Koch Inc., Non-Standard Finance Plc and Zenith Group Holdings Ltd. all recently met their financing needs via a direct lender rather than going the traditional route of a bond sale.

5. What’s driving the growth?

Investor demand, driven by the search for yield. And a sort of virtuous cycle -- as more money comes into direct lending, fund managers are able to write bigger loans, which makes direct lending even more attractive. Asset management firms are raising a lot of money from pension funds and institutional investors that need to deploy cash and find yield in a low-rates environment. There’s also demand for funding from small and medium enterprises (SMEs) that have struggled to get loans from the more cautious banks and are unable to issue bonds. At the lower end of the high-yield spectrum, direct lenders can be attractive to companies facing business-specific or sector-wide challenges.

6. How risky are the loans?

Getting a little riskier. While the direct-lending business grew up concentrating on solid, safe companies that were just the wrong size for banks, a growing number of direct lenders are extending higher-risk debt financing to more distressed companies. Some funds are buying into so-called story credit -- lending to companies that are seen as higher-risk after a financial restructuring or other difficulty. That’s partly a reflection of how competitive the market has become.

7. What’s the case for direct lending?

The main thing is that direct lenders say yes to companies banks no longer want to lend to. And as direct lenders are not subject to capital requirement guidelines, they are able to take on companies with higher leverage, which means attractive returns for investors if the deal runs smoothly.

8. What are its downsides?

The extra leverage that can make direct loans look more attractive can also make outcomes uglier if the economy or markets hit a rough patch. Borrowers might not like the fact that a single lender can have more power in negotiations than a group might. And like the rest of the shadow banking sector, direct lending operates without regulatory oversight. European Central Bank Vice President Vitor Constancio has called for “pre-emptive” regulation of non-bank lenders to ward off a build-up of systematic risk.

The Reference Shelf

— With assistance by Marianna Duarte De Aragao

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