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“Passing the Test” – Direct Lending in the Aftermath of COVID-19

After a challenging year, the economic tide appears to be finally turning. There is now reason for cautious optimism around economic and investment activity. While difficult in many obvious ways, lockdowns have also seen household savings rates surge in most developed economies, as well as an uptick of individuals making repayments to consumer credit. Over the coming months, private consumption is anticipated to rebound as lockdowns ease, especially in some of the hardest hit sectors. Early evidence of recovery is already showing in company earnings.

SMEs continue to have ready access to capital at attractive cost, providing a supportive environment for investment, backed by constructive monetary and fiscal policy. The potential impacts of government intervention during the pandemic are becoming clearer. Near-zero interest rates and heavy fiscal spending have also laid the foundations for monumental economic stimulus. This creates a scenario where the risk of rising inflation emerges, making the pursuit of real returns even harder than before. It is a complex environment to navigate as an investor. Little wonder that the pursuit of yield has become a dominant debate. This is where direct lending comes in.

The continued evolution of direct lending

Having faced its sternest and first real test since its inception after the global financial crisis, direct lending has taken another important step forward as a fast-maturing asset class. This is a notable moment. Not only has it played an essential role for almost a decade in filling the capital holes left by previous economic dislocation, but 2020 will be seen as the year that European direct lending has worked as designed for investors, providing attractive returns with robust downside protection even during turbulent economic conditions. Broad sourcing networks, rigorous due diligence and structuring, discipline in selecting credits, high degrees of portfolio diversification and excellence in portfolio monitoring all have served to protect investor capital and drive returns.

With banks constrained by capital and increasingly stringent regulatory requirements, particularly those that lend to SMEs, private markets continue to show that they offer useful alternative access to financing. Many viable businesses – with positive cashflows and robust balance sheets – turned to direct lending for capital solutions prior to and throughout the pandemic. This theme looks set to continue, even in periods of economic prosperity. It will benefit those in the direct lending sector whose long-term and disciplined approach is delivering results and meeting client expectations.

Strategic activity is likely to continue apace, providing more investing opportunities for direct lenders. As with any downturn, the economic reality of Covid-19 is that better managed businesses are likely to look for market share opportunities by acquisition. Alongside this, smaller players might not be able to weather the profitability and capital challenges brought about by the strains of the pandemic. These factors are likely to drive sector consolidation. With large pools of private equity and debt dry powder, private markets are well placed to support LBOs and growth via acquisition. Similarly, in a low yield environment, with the inflationary outlook uncertain and highly priced equity markets, floating rate private credit is also likely to become an even more important part of institutional investment portfolios to drive attractive risk adjusted returns.

We believe that the constraints of traditional bank lending are here to stay, and that private markets will become an even more attractive alternative source of funding for businesses across the capital structure. As a potentially long and uneven journey toward global economic recovery begins to take shape, there are likely to be more complex funding needs emerging. The appeal of direct lending will become even clearer as the asset class continues to prove itself a mainstay in portfolios, having now been stress-tested by a global pandemic and related economic pressures.

The core tenets of a successful direct lending strategy include a sharp focus on origination, which provides a broader range of opportunities and thus the luxury of selectivity; guardrails around country and sector focus to ensure that only those opportunities that are robust and resilient are considered for investment; a focus on due diligence, protective structuring and disciplined credit selection; the necessity of diversified portfolios around sector, geography and borrower size; and rigorous and active portfolio monitoring to protect deployed capital to ensure its safe return to investors. Adhering to these tenets was important before the global pandemic, and remains critical.

The sturdy performance of European direct lending through its first crisis test during the pandemic leads to a positive outlook for the asset class. As the economic tide turns, firms who adhere to these tenets while providing dynamic solutions to borrowers are well-positioned to deliver attractive risk-adjusted returns to clients.

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Peter Glaser is Head of European Direct Lending at Alcentra

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group

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