What’s direct lending? Old-fashioned bank lending -- without the bank. As tougher regulations reshaped the post-financial crisis landscape, traditional banks have cut back on business lending. That’s created a raft of opportunities: For a growing group of asset managers who are making the loans; for borrowers, including not only mid-sized companies but some big enough to tap the syndicated debt markets if they wanted; and for investors looking for an answer to low-yield woes. For regulators, the question 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 higher-yielding 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.

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2. Who borrows from them?

Typically, what are known as “mid-market” businesses that banks are no longer interested in lending to. Their need for credit and lack of good alternatives means direct lenders have historically been able to extract higher interest rates -- though reaching that higher yield is expected to become more challenging amid increased competition for business.

3. Why is direct lending in the news?

Direct lenders are consistently accumulating large sums of money and pursuing different types of deals. Roughly a third of investors surveyed by research firm Preqin plan to invest more in private debt in 2019 than in 2018, with nearly half intending to boost their allocation long-term. Capital raised for private debt strategies reached $110 billion in 2018, following a record of $129 billion the previous year, according to Preqin, with 41 percent of the money secured to direct-lending funds. This has taken the industry to almost $770 billion in assets under management as of June from $275 billion in 2009. North America is the biggest center for direct lending, with a 61 percent share of the market, according to Deloitte.

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4. How are the deals changing?

In the U.S. and Europe, intense competition for deals has led to weaker protections for lenders in many cases. It’s similar to what’s happened in the larger market for broadly syndicated loans. Borrowers that have previously tapped the traditional leveraged loan market for their debt are increasingly pursuing direct loans instead as well. And the growing firepower of private debt funds mean they have been able to write bigger checks for single deals. For example, Ares Capital Europe in February said it provided a 1 billion-pound financing to U.K. telecom services firm Daisy Group in one of the biggest private debt transactions in Europe. Often funds also team up to offer larger financing packages.

5. What’s driving the growth?

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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-rate environment. There’s also demand for funding from small- and medium-sized 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.

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6. How risky are the loans?

Getting riskier. As the cycle has reached its later stages, credit quality has deteriorated across the board. While the direct-lending business grew up concentrating on solid, safe companies that were just too small 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.

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7. What’s the case for direct lending?

The main thing is that direct lenders say yes to companies that banks don’t want to lend to. And as direct lenders are not as constrained by capital requirement guidelines, they are able to take on companies with higher leverage, which means attractive returns for investors if the deal runs smoothly.

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8. What are its downsides?

The extra leverage that can make direct loans look more attractive is likely to put a damper on recoveries in a downturn. UBS credit strategists have flagged private credit as “ground zero” for concerns in such a scenario. 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. Lastly, new entrants to the space may face challenges during a slowdown. Jamie Dimon, CEO of JPMorgan, said some non-bank lenders may not survive an economic slump because they’re holding lower-quality loans -- and their disappearance could leave some borrowers “stranded.”

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(Corrects date of Ares transaction and clarifies which unit provided the financing in fifth paragraph.)

--With assistance from Marianna Aragao.

To contact the reporters on this story: Hannah George in London at hgeorge13@bloomberg.net;Kelsey Butler in New York at kbutler55@bloomberg.net

To contact the editors responsible for this story: James Crombie at jcrombie8@bloomberg.net, John O’Neil, Laurence Arnold

©2019 Bloomberg L.P.

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