Direct lending is a growing opportunity for investors and a logical fit for active managers with analytical prowess and global scope.
Major changes in the banking industry occurred in the wake of the Global Financial Crisis of 2007-2008, opening up expanding opportunities for active managers to find value for clients through direct lending investments. Direct lending, which involves making loans directly to business and consumers, is a logical extension of the credit analysis that active managers routinely perform. Yet it is more complex than traditional sectors. Less information is publicly available about the borrowers, and liquidity can be limited, putting a premium on experience and expertise.
Lending standards have tightened
The global financial crisis of 2007-2008 brought momentous change to the banking industry, including new regulations governing lending standards and capital requirements. As a result, lending conditions tightened, which made it unprofitable, if not impossible. for many banks to provide loans to many qualified borrowers.
The crisis impacted the banking sector first by causing destabilizing loan losses and then by spawning a wide net of new regulatory actions including those laid out in Basel III—a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk—and in the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in the United States. These actions included higher capital requirements (how much cash must be kept on hand relative to the level of outstanding loans) and more stringent lending standards (guidelines that establish benchmarks for making loans to companies and individuals).
The natural consequence of loan losses and tighter regulations was less available banking capital and a more cautious view toward new loans. The decrease in available capital corresponded to a drop in loan demand due to the rapidly-developing recession which accompanied the global financial crisis. However, once economic activity picked up again, the demand for loans recovered as well, despite banks' inability or unwillingness to satisfy that demand. Residential, commercial and consumer lending sectors in the US and in Europe have all been impacted by banks’ reduced ability and desire to make certain types of loans.
Direct lending helps close the gap
Private capital stepped in to help meet this unmet demand. The United States already had a rather well developed private lending market operating alongside traditional banking, so direct lenders were at the ready to help pick up the slack. In Europe, a much greater reliance on banks for all types of loans made the situation more acute, but that has resulted in faster growth in alternative lending in recent years. The direct lending market in the US is still the largest and most active and growth in Asia is clearly evident, but Europe is considered to offer abundant opportunity because many banks there are looking to sell existing direct loans to private investors.
Cui bono – who benefits?
Direct lending gives the asset manager involved more control over the original terms and conditions of the loan, which may result in higher yields, discounted pricing and stronger debt covenant protections than what’s available through traditional loans funded by financial intermediaries such as banks and institutions.
For borrowers, direct lenders can offer a number of advantages that are outside the reach of traditional banking finance, including the ability to move quickly and provide more flexible loan terms, as well as offer more sophisticated solutions tailored to their specific needs
For investors, it’s another way that active managers seek to add incremental value to broader portfolios. Through direct lending, active managers seek attractive risk and return characteristics and make them available to clients through a variety of generally less liquid vehicles based on client preferences. The potential for attractive total return is embedded in the higher income that may be earned in part due to lower liquidity in the sector. This makes loan selection and diversification especially critical.
The advantage of scale
Large, well-established, global asset managers may be best positioned to identify attractive direct lending opportunities as thorough analysis of individual investment ideas is critical to assess if the potential for return justifies the risk. In fact, credit analysis can be a resource burden for direct lenders that don’t have scope and analytical prowess, while sourcing new opportunities may also be more difficult for those who don’t already have widespread existing relationships with loan originators and participants in this market. Asset managers with global scope and experience may also be better able to pursue a broad range of loan opportunities in multiple markets and sectors to maximize the potential for choice and diversification.
The bank funding gap created by the Global Financial Crisis still exists to a considerable degree today. Banks continue to deleverage and grapple with the constraints of new regulations, but the recovery from the crisis continues and that means ongoing demand for new funding.
Although the global market for direct lending is still relatively small, it has grown quickly and asset managers will undoubtedly continue to provide credit to worthy borrowers in this environment. With clients continuously looking for innovative ways to pursue higher income and return opportunities and to diversify their investments, Legg Mason will continue working to expand the choices available to them, such incorporating direct lending into their allocation mix.