More and more, private equity firms looking to finance big leveraged buyouts are cutting out the Wall Street banks, and borrowing money from each other or from direct lenders.

Private equity firm Thoma Bravo bypassed banks when getting $2.6 billion of debt financing for its buyout of in July, and for a $2.3 billion loan for the buyout of Calypso Technology Inc. in April. In early 2019, these loans rarely exceeded $500 million. But the funds that provide them are swelling, and the financing offered increasingly tops $2 billion.

“What is possible in terms of size got a lot bigger,” said Tom Connolly, co-head of the private credit investing business at Goldman Sachs Asset Management. “What’s new right now is the scale.”

These loans often come from the credit arms of private equity firms, or from standalone direct lending funds. The appeal of this financing for buyouts is the process is easier and sometimes lenders will offer more debt. But for banks, the transactions threaten one of the most profitable businesses on Wall Street: leveraged finance, where groups of banks arrange loans and junk bonds to fund private equity deals.

The potential pain for banks that results could be intense. Leveraged finance generates about a third of Wall Street’s investment banking fees, and now many direct lenders are competing for those deals alongside big banks. One strategist estimates that direct lenders could snag as much as a tenth of the loan portion of that business in the coming months.

The direct loans are often in the form of unitranche financing, which include elements of conventional loans and unsecured debt. About a dozen firms are making unitranche loans of this size, typically as part of a small group, include Blackstone Group Inc., Apollo Global Management Inc., Ares Management Corp., Blue Owl Capital Inc., KKR & Co., Goldman Sachs Asset Management, and Golub Capital.

To take private, Thoma Bravo called upon Blackstone, Ares, PSP Investments and its own credit business for a $2.6 billion loan. The debt was structured as a unitranche, and was the biggest such transaction on record.

Direct lending funds are now sometimes offering private equity firms more leverage than they might get in the syndicated loan market, and the financing can be faster, potentially shaving four to five weeks off the deal time. Going the direct lending route can also be easier for the borrower, and can ensure that few other parties find out about a deal.

Of course, syndicated loans historically charged lower yields, and terms known as covenants were looser, which allowed banks to win deals. But that’s changing in certain cases: some of the bigger direct financing loans now don’t require the borrower to meet performance tests over time, to compete with so-called covenant-lite loans that come through banks. And the premiums for direct loans are increasingly shrinking, making their yields more competitive with their syndicated counterparts.

“It’s the confidentiality, it’s the speed, it’s the certainty, knowing up front what terms you are getting,” said Laura Holson, head of capital markets at New Mountain Capital, who helps the private equity firm find financing for its buyouts. “It can be more efficient to have a small handful of groups to go out as opposed to a syndicated deal where you might have a 20, 30-plus group. That’s a lot of cats to herd.”

In the early days of buyout financing, private equity firms mostly relied on banks for safer senior debt alongside credit funds for the riskier portions, and public markets for bigger deals. Then after the financial crisis, banks cut back on LBO lending as regulatory changes made it more onerous for them to hold onto the debt. For larger buyouts, investment firms running collateralized loan obligations provided more loan financing, with the banks staying involved mainly as middlemen.

For smaller deals, direct lenders stepped in to provide financing straight to private equity without banks intervening, and later started to provide financing to larger deals that would have struggled to sell in public markets. But now they’ve been taking bigger deals that could easily have been sold in the broadly syndicated loan market, meaning the funds are increasingly eating away at the heart of Wall Street banks’ business.

In many deals now, private equity firms consider both syndicated loans and direct financing to see which will be better for them. Veritas Capital looked at the two possibilities before opting for a $2.15 billion private unitranche for a recapitalization of Cambium Learning Group Inc., according to people familiar with the matter.

Thoma Bravo had discussions with both banks and direct lenders for, said the people. Medline Industries is getting around $17 billion of debt financing as part of its buyout, which was too big for private credit to take down on their own, but at least one firm vied with banks for portions of the debt, according to a person familiar with matter.

“Simply put, the direct lending market is taking some share from the broadly syndicated market,” said David Golub, president of Golub Capital, a direct lender.

Sometimes investors in direct financings are willing to take more risk than their syndicated loan counterparts might. For example, in the buyout, debt is equal to more than eight times a measure of income known as earnings before interest, taxes, depreciation and amortization, according to people familiar with the matter.

That’s more than would likely be possible in the loan market, people said. And the borrowers are paying only a bit more than they would for comparable syndicated loans, according to one of the people. Historically, direct loans had higher yields than leveraged loans, but increasingly, jumbo unitranche deals are paying similar levels.

“Private credit providers will match covenants and push leverage beyond where banks for regulatory reasons are willing to go,” said Randy Schwimmer, co-head of senior lending at Churchill Asset Management, a direct lender. “And they’ll transact more quickly, with price certainty. It’s tough to match.”

Ares Chief Executive Officer Michael Arougheti anticipates unitranches as large as $5 billion in the near future, though not in 2021. Blue Owl co-President Marc Lipschultz has said the market has adequate capital to support a unitranche of that size. Other investment firms agree that the large amount of uninvested capital in direct lending funds is allowing deal sizes to keep getting bigger.

“Up to now, what’s been holding the market back is really scale,” said Brad Marshall, co-head of performing credit at Blackstone. “Last year we did six deals that were a billion-plus each. We’ll commit to at least that in the second half of this year.”

These funds can win a material portion of the leveraged loan business, said Matthew Mish, credit strategist at UBS Group AG.

“For the rest of the 2021, it’s possible that direct lenders steal as much as 10% of the rest of the leveraged loan calendar,” Mish said.

As direct lenders have grown bigger, unitranche deal volume has soared. In the second quarter there were about $21.6 billion of those transactions, compared with about $3 billion during the same time period in 2016, according to data from Refinitiv LPC.

“As the private credit business continues to evolve and expand, it’s becoming a true product offering versus the syndicated loan market, or versus the high-yield market,” said Dan Pietrzak, partner at KKR, referring to unitranches. “You should expect to see more of them.”

The growth of the direct lending market is fueling this shift. These funds have reached $1 trillion of assets under management, about double their level in 2015. Last year it looked like the growth might be checked, after Covid-19 damped the number of unitranche deals in the early days of the pandemic.

The Federal Reserve opted not to provide direct lenders with the same backstop given to public credit markets like corporate bonds. But then, as yields fell, investors began looking for higher returns, and poured money into private credit funds anyway, allowing for ever-bigger deals.

“The pools of capital are growing and with fixed income yielding close to zero, all of that fixed income capital has to go into higher yielding product, which is really private lending,” said John Zito, deputy chief investment officer of Apollo Credit. “In the back half of the year, the amount of pipeline for new commitments is very large.”