What do private equity buyers want from lenders? Speed and certainty of execution. Enter direct lenders, which are bypassing traditional banks. We spoke with several firms leading the way.
In today’s highly competitive M&A market where mega deals are back, dealmakers are demanding more flexibility and certainty from loans to fund acquisitions. To find better ways to achieve these results, private equity buyers are going to direct lenders, which are increasingly other PE firms, instead of investment banks and other traditional lenders.
“Private credit can offer both speed and certainty of execution compared to traditional broadly syndicated loans and high-yield financings, primarily because private credit cuts out the market execution risk and costs that come with traditional underwritten bank transactions,” Taylor Boswell, chief investment officer of Carlyle direct lending, tells Mergers & Acquisitions. “All leveraged finance markets—traditional broadly syndicated loans, high-yield financings and private credit—are experiencing secular growth driven by increased bank regulation and an expanding private equity asset class. Private credit, however, is gaining market share compared to traditional liquid markets, largely, we believe, because of the speed and certainty of execution offered.”
Banks and other traditional lenders will continue to face rising competition, according to one direct lender, and those that can’t offer a one-stop shop to PE firms and buyers will likely see a drop in business. “The market share of traditional lenders is likely to continue to fall as direct lenders continue to grow available capital to provide solutions across the lower midcap, midcap and upper midcap sectors,” says Stuart Aronson, the group head of WhiteHorse Capital’s U.S. direct lending platform. Whitehorse is H.I.G. Capital’s lending arm and raised a $1.65 billion direct lending fund in July.
Direct lending has been growing since the global financial crisis when legislation was put in place in 2010 that made it harder for banks to make leveraged loans. This has led to a rise in the number of alternative lenders, including those affiliated with PE firms, which have expanded into lending and find the industry attractive because of the ability to leverage many of the same skills used in the investment process, says Walter Owens, the CEO of Varagon Capital Partners, a direct lender to middle-market companies. “Private lenders have been expanding their market share since the GFC when banks were increasingly regulated out of offering competitive loan structures to borrowers and PE firms,” he says. “As there is no expectation that regulators will loosen bank requirements near-term, we anticipate this trend will continue.”
“Banks typically underwrite a whole loan while intending to hold only a fraction of the facility,” adds Owens. “The resulting syndication requires ‘market flex’ in the terms to allow for market-based changes if needed, and typically takes four to six weeks after the initial commitment is made to close. Unitranche loans, in contrast, have greater certainty around terms and can typically close more quickly because the lender committing to the loan wants to hold most or all of the facility. This is advantageous to PE firms, especially in competitive situations where they’re trying to make a strong bid for a company to beat out other sponsors.”
The Private Equity Equation
One way PE firms are getting more involved in direct lending is by raising funds themselves. This includes credit arms of funds. That is what WhiteHorse did with its latest fund that lends to lower mid and middle-market companies across the business services, manufacturing, healthcare, retail, food and agriculture sectors. H.IG. formed H.I.G. WhiteHorse in 2011 when it acquired certain assets of WhiteHorse Capital.
“Our latest fund is focused primarily on the non-sponsor mid-market and lower mid-market,” Aronson says. “Unlike many other firms which source their non-sponsor deals in bank auctions, we seek to directly originate our deals from the 12 regions where we have a physical presence and also through a business development team which calls into a proprietary database of over 20,000 names of CEO’s, CFO’s, business brokers, attorneys and accountants.”
PE firms are flush with cash, and they need to put that capital to work so they can make returns on their investments for limited partners. These strategies include expanding into other areas, such as private lending. In April, Ares Management Corp. (NYSE: ARES) raised about $13 billion in its fifth European direct lending fund. At the time, Michael Dennis, partner and co-head of European Credit at Ares said: “We believe the scale of our capital remains a key differentiator due to our ability to provide flexible, one-stop financing solutions, making Ares an attractive direct lender to companies seeking a long-term partner to sustain their growth.”
Ares formed its European direct lending business in 2007 to take advantage of what was then still a relatively new and growing market segment, the firm said. Today, Ares has one of Europe’s largest dedicated direct lending teams with more than 70 investment professionals across six originating offices. Since it was founded, Ares’ European direct lending business has completed about 235 investments.
“Generically speaking, private equity firms are always looking for ways to become more relevant to their LP bases,” says Chris Flynn, president of alternative lender First Eagle Alternative Credit. “Another way to leverage their brand and existing relationships is simply to raise more capital for adjacent strategies, whether it be $500 million or many billions. We don’t see the trend slowing down.”
When it comes to fundraising, PE firms have all the momentum right now, because buyout shops have more resources at their disposal with relationships and their ability to raise funds quickly in the current environment.
“We believe alternative lenders will continue to raise direct lending funds, and that those funds will have increasingly large targets,” says Owens. This is based on a couple of drivers, he adds, including general strong performance across direct lending funds, even during the pandemic.
In September, HPS Investment Partners closed its largest direct lending fund at $11.7 billion. The firm’s direct lending platform has invested over $55 billion across more than 375 portfolio companies since 2010.
“Many investors that have historically allocated to direct lending strategies with good results have signaled they will increase their target allocations, while some investors that haven’t previously allocated to private credit strategies are beginning to evaluate the sector,” Owens adds. “Direct lending is often the first strategy under consideration because of the historically attractive outcomes of low defaults and solid returns.”
Leg Up on the Competition
Lenders that do not have their own origination functions or can’t find other ways to make themselves stand out will likely lose out to direct lenders. Private loans to fund large deals have become more common, including a loan to finance Thoma Bravo’s $6.6 billion take private of Stamps.com. Thoma Bravo bypassed banks to get financing for its acquisitions of Stamps.com and Calypso Technology Inc. For example, Blackstone Credit was one of the direct lenders on both deals.
“Some of these mega managers are raising massive amounts of capital and are being less restrictive,” says Robert Grunewald, founder and CEO of Flat Rock Global, an alternative credit manager that lends to the lower middle-market. “For example, the Blackstones of the world are taking away market share from banks and other lenders, because they can write bigger checks themselves with fewer terms. If you are the PE firm borrowing the money, you have to talk to these mega managers, because they’re saying ‘hey, you want to come to us because you can close the deal quickly and with fewer covenants.’” Grunewald says he likes the lower middle-market, as opposed to larger deals, because of the ability to get better yield, with stronger covenants, and without having to compete with the Blackstones of the world, which are focused on writing larger checks.
Direct and alternative lending has been around for years and is expected to continue to take off in popularity. Mega funds, such as Blackstone, are diversifying into other asset classes, such as private credit. And because these big firms can write bigger checks to fund large deals, they have become an attractive lending option to buyers.
“We believe that the direct lending market will continue to see a shake-out between those lenders, such as Monroe, that originate their own product and offer LPs something unique” says Chris Lund, managing director and assistant portfolio manager, private credit vehicles at Monroe Capital. “Direct loans from PE firms are generally not resulting in more competition for Monroe. Our value proposition is largely predicated on being a one-stop-shop who can provide execution certainty and can help our borrowers grow over time. We are typically the agent on our credit facilities, and we are often the only lender in our deals. In our segments of the market (lower middle-market, software and technology lending, and opportunistic debt), we generally don’t see PE firms looking to compete for the agency on our debt deals — in part because PE-backed borrowers are generally not eager to allow competitor PE firms to have such an important role in the success of their portfolio companies.”
The Flexibility Factor
Buyers need lenders that can deliver so they can close their deals quickly and with minimal disruptions and issues. Direct lenders are becoming more of a preference in this regard. “A direct loan is critical as it helps close deals, and those deals would not be possible without direct lenders,” mentions Flynn.
One key benefit of going directly to a large fund for is that, in many cases, the firm is backing the entire deal itself. That means buyers are usually only dealing with one lender, they can get lower interest rates, more flexibility on covenants, and see their deals close more quickly and smoothly. If you compare that with going to a traditional bank to fund a multi-billion dollar deal, and the bank only has the capacity to fund a few hundred million, the bank will likely have to pool that loan with a group of other lenders. Then buyers can see the closing process drag out.
Flynn also points out that lenders need to develop sector expertise alongside PE firms to help keep up with competition. “As private equity firms become sector-specific, so are alternative lenders,” he says. “We’re developing sector expertise that match private equity firms’ own expertise, and it’s been a successful strategy.”
With dealflow bustling, competition among lenders is out in full force.