Why did you decide to research this area?
“Direct lending is becoming an increasingly important part of the debt market and is replacing existing lenders, yet there has been little academic research on it until recently. There is a tendency to believe that banks hold a special place in the lending market because they are relationship-oriented, and they try to understand the companies they lend to by gaining soft information about them.
“By contrast, some people have raised concerns that credit protection is weak in non-bank lending and that non-bank lenders tend to behave in a more transactional way. This seems to be particularly true for non-bank lenders, such as collateralised loan obligations, hedge funds, finance companies and so on. I wanted to test whether this was really the case for direct lenders. My research focuses on direct lenders acting as lead lenders in senior loans for buyout situations.”
One finding that may be surprising is that 98% of the direct loans in your sample contained financial covenants, with an average of 1.5 financial covenants per loan – more than with banks and with more equity cure rights. How surprised were you?
“It’s worth emphasising that I focus on first lien, senior loans to private equity-backed buyouts, where the lead lender is not a bank, so while this does not cover the private credit spectrum, it does cover the vast majority of direct lending-type activity.
“I had expected most direct lending documentation to include financial covenants, but was surprised that practically all agreements contained them. What’s also interesting is that in an earlier version of the paper, I found that there were tighter negative covenants in direct lending agreements than those with banks. For me, that speaks to lenders wanting to restrict a company from taking certain actions to manage credit risk, but if the company then wants more flexibility, it can reach out to the lenders again and renegotiate. Transactional lenders wouldn’t behave in that way – they would just create a contract and wait until it matures or defaults. Direct lenders, though, seem to behave more like relationship lenders.”
There is a tendency to believe that banks hold a special place in the lending market because they are relationship-oriented.
Young Soo Jang
That focus on relationships is also evident in your findings about direct lenders’ responses to company distress. What are the most important points there?
“When a company goes into distress, there are two main options – put the business into bankruptcy or try to renegotiate. The issue with banks is that they tend to syndicate the loans to diversify their portfolios or lower the amount they hold because of the regulatory capital cost, and if you have a lot of different debt holders, you run into holdout issues. It only takes one lender not to agree to new terms and then it almost becomes inevitable that the company goes into bankruptcy. When that happens, the borrower’s liquidation risk goes up markedly.
“Direct lenders, however, have more concentrated holdings and are often sole lenders. They get to make the decisions, and my research suggests that those decisions are highly influenced by the fact that sponsors are their major clients. They want to retain those relationships to ensure they get deal opportunities in the future. In fact, my paper highlights these repeated interactions with sponsors and how important they are for direct lenders.”
There is an alignment of interest, where it is beneficial to both sides to support a company to get it through a difficult patch, as opposed to putting it into bankruptcy and trying to work it out.
Young Soo Jang
So does that mean the sponsors are in the driving seat when it comes to distressed situations?
“That is a potential concern – it could be the case that direct lenders don’t have any bargaining power with sponsors. But that’s not what I have found. It seems to be the case that this is a two-sided, mutually beneficial relationship, because in distressed situations with direct lenders, sponsors are more likely to inject equity and increase their skin in the game than when a bank is the lead lender. There is an alignment of interest, where it is beneficial to both sides to support a company to get it through a difficult patch, as opposed to putting it into bankruptcy and trying to work it out.”
Overall, what conclusions should readers draw from your research about the importance and riskiness of direct lending versus bank lending?
“At first glance, it may seem as though the importance of banks is diminishing. Yet they remain vital for the economy and even for direct lenders themselves. My paper shows that direct lenders are effective at credit risk management – they put in place covenants, monitor them, and have the capacity to be flexible when companies get into trouble.
“However, their funding is largely sourced from limited partners’ long-term capital. They are not designed to create liquidity. That’s where the banks come in and that’s why they have a special place in the economy. Banks can provide short-term liquidity and funding to companies, and they provide credit lines to direct lenders themselves – it may well be that direct lenders couldn’t achieve what they do without the banks.”