Written by: Richard T. Miller and Ryan K. Carroll | TCW
During periods of increased market volatility and greater economic uncertainty like we have experienced in the past 18 months, we believe direct lending portfolio managers should strategically prioritize a few key items. First, is a focus on managing existing legacy portfolios. Second, managers should actively pursue new loans that reflect the improved riskreward investment environment. The third, often overlooked, priority should be to strategically exploit opportunities created by excessive risk-taking in recent years in middle market direct lending. Managers should identify overlevered, liquidity-challenged but otherwise worthy businesses in lenders’ legacy portfolios and provide these struggling businesses necessary, attractively-priced and well-structured capital.
In several previous papers, including The End of the Beta Trade, COVID-19 & Covenants, and Resiliency in Times of Turbulence, we discussed managing middle market direct lending portfolios given our belief that this market is likely to be very different in the next few years when compared to the previous 12 years. Our expectation is that existing direct lending portfolios will be tested, and investors will be better able to differentiate among direct lending managers and their respective strategies. In our view, only those managers who have employed consistent lending discipline – reflected in conservative credit metrics, actionable loan documentation, active monitoring and decisive, aggressive portfolio management focusing on principal preservation – will successfully earn above market returns through a credit cycle.
Regarding the pursuit of new loans in the improved risk-reward environment, we believe the current direct lending opportunity is as attractive as we have seen in over a decade. Since early 2022, market conditions have improved materially and negotiating leverage has swung towards lenders, particularly for non sponsor-backed borrowers and in refinancing transactions, resulting in higher yields, lower closing leverage ratios, and the return of more reasonable documentation. Recently, direct lending investors have also enjoyed much higher interest rates. Today, with the Term SOFR base rate surpassing 5%, coupons and return expectations in middle market direct lending are into double-digit territory. While the improved conditions for making new loans will not be able to remedy problems in existing legacy loan portfolios, we believe middle market lending remains highly attractive during uncertain, higher-risk investment periods, because the asset class benefits from its highest-priority, senior secured position in the capital structure, a floating interest rate that compensates for rising inflation, and the protections of an actionable loan agreement.
3-Month Term SOFR (%)
Source: CME Group
In this paper, we focus on the third priority: the opportunity for direct lenders to identify over-levered businesses with a path to financial stability that need additional liquidity. In 2021, there was record issuance of loans in the middle market, and leverage levels also reached record highs. Many of these capital structures were established with the myopic view that interest rates would stay low forever. Instead, interest rates have rapidly climbed, and higher rates, combined with elevated debt levels, falling enterprise value multiples, and a lack of financial covenants, are creating challenges in many lenders’ legacy portfolios. The challenges will increase further if economic growth weakens or plateaus. We believe these factors have created an environment for a compelling rescue investment opportunity in the direct lending middle market.
Middle Market Issuance Volume (US$bn)
Source: Refinitiv LPC
Middle Market First Lien Leverage Multiples (Debt/EBITDA)
Source: S&P LCD Comps * 2020 is extrapolated by TCW due to lack of available market data
Stressed and Distressed Opportunities in Direct Lending
We have witnessed and expect many borrowers with over-levered capital structures to become further liquidity constrained, which will threaten their long-term viability and require incremental capital to survive the dramatic increase in their debt service obligations. For example, as detailed in the chart below, if a company took out a loan in 2021 and was levered at 5.0x debt/EBITDA with a base rate floor of 1%, and a spread of 5%, 30% of the company’s annual EBITDA was dedicated to pay the 6% cash interest coupon. Today, the base rate of that loan (SOFR) has increased to nearly 5.5%, resulting in a cash interest coupon of 10.5%. If EBITDA has not increased, more than 50% of the borrower’s EBITDA will now be needed to pay the company’s interest expense.
The charts below reflect calculations performed by Lincoln International based on data from the Lincoln International Private Credit Index (the”Lincoln Index”) and provide further insight into the impact of higher base rates on the middle market as a whole. Assuming a full year of SOFR at 5.5%, approximately 30% of borrowers in the Lincoln Index will not be able to cover their interest expense and over 40% would be unable to cover fixed charges. Absent new capital, these borrowers are running out of money.
Size-Weighted Percentage of Companies with Interest Coverage and Fixed Charge Ratios Under 1.0x
Interest Coverage Ratio Fixed Charge Coverage Ratio
Source: Lincoln International
We believe middle market direct lending managers who can identify and successfully work with the management and owners of these liquidity-challenged businesses will be best positioned to invest new capital. Critical to investing successfully in this environment will be the manager’s ability to perform rigorous due diligence to gain insight into the current situation and develop a capital structure that works for the borrower by supporting a strategy to improve operations while adequately compensating investors. By offering incremental capital as part of a complete solution, new lenders provide these borrowers the time and the incremental liquidity needed to manage through the difficult period. As a new money provider, the lender should be able to negotiate a customized loan document with covenants and performance milestones tailored to mitigate identified risks while providing the company’s management team an opportunity to guide the company back to health. Due to the challenging situations facing these borrowers and limited capital alternatives, the cost of capital for these liquidity infusions will likely be high, making for attractive investment returns for investors. Importantly, by investing in first lien, senior secured loans governed by an actionable loan agreement, this approach prioritizes principal preservation and positions the lender to have material influence and protection if the turnaround strategy is not successful.
In our view, many direct lenders are ill-equipped to deal with the challenges of managing underperforming businesses back to profitability. Most middle market direct lending managers have only operated in an environment of low interest rates, reasonable economic growth and unusually low default rates. Approximately 95% of the direct lending funds raised since 2000 were established following the Global Financial Crisis. Few have invested and managed portfolios through challenging economic periods, when interest rates and default rates rise, and owners become unwilling or unable to support their companies with incremental capital. This lack of experience and expertise will create additional investment opportunities for those managers who can step in and manage underperforming borrowers.
Direct Lending Funds Closed1
Source: Preqin 1 Represents the number of funds raised
While we expect to see conventional liquid distressed investors attempt to pursue this investment opportunity, we believe the middle market could present challenges for these investors. Typically, liquid distressed or stressed managers look to acquire discounted claims in the secondary market and negotiate an exit to achieve their targeted recoveries. This approach will be more difficult in the direct lending middle market due to the lack of a secondary market for private middle market loans and the limited amount of information available to potential debt buyers. Even if investors were able to purchase minority positions in middle market loan syndicates, the lack of actionable triggers due to the proliferation of covenant-lite and covenant-wide features in loan documents over the past few years will likely limit investors’ ability to drive meaningful change in a timely fashion.
After an extended period of near zero interest rates and the ensuing aggressive lending practices, conditions have changed. In many instances, these changes will require balance sheet restructurings, bankruptcy filings and new capital infusions to reposition borrowers to succeed. Importantly, this environment creates opportunities for managers with the capital, experience, and expertise to navigate a volatile economic environment to establish a portfolio of high-returning, senior secured loans with strong downside protections and low risks of principal loss.
Related: 3 Timely Sources of Yield Potential to Enhance Returns