Direct Lending Outlook High Return Potential, More Deal Activity

By Brent Humphries & David Kuck

Asset yields may be slightly lower this year. But for disciplined managers with strong portfolios, we think the return potential exceeds historical levels.

In our view, 2024 could extend the trend of rewarding years for investors in direct lending strategies. While higher-for-longer interest rates, slower growth and stickier inflation may present challenges for some borrowers, we don’t expect credit losses to become unhinged. Instead, we think the benefits investors are seeing from higher rates will outweigh pockets of concern in portfolios and create attractive new opportunities for selective lenders.

High interest rates in 2023 cooled deal activity, which had hit record levels in 2021 and 2022. Despite the lower volume, returns for investors in direct lending peaked last year, as the benefit of higher rates and the recoupment of mark-to-market markdowns taken in 2022 more than offset a modest uptick in losses.

Looking ahead, we are optimistic that we’ll see another year of strong performance in direct lending strategies, driven by attractive asset yields and resilient fundamental performance among middle market borrowers. What’s more, we expect a meaningful increase in deal activity given general market sentiment that base rates are likely to moderate.

Here’s a closer look at what we think investors can expect this year:

1. A (Moderate) Decline in Asset Yields, but Above-Average Return Potential

The Federal Reserve may cut the federal funds rate as early as the middle of the year. But recent data showing that core inflation rose unexpectedly in January suggest policymakers may wait a bit longer than previously expected to start easing. We think the pace of easing is likely to be gradual, as the labor market continues to exhibit strength and inflation remains above the Fed’s target.

The forward curve for the Secured Overnight Financing Rate (SOFR), the base rate used to price direct corporate loans, suggests the rate will decline to about 4.5% by year-end, from above 5% today. But we expect it to stay well above the sub-1% levels that prevailed for more than a decade after the global financial crisis. Simply put: high base rates lead to high yields on loans, and that suggests higher return potential for direct lenders (Display).

New Issue Yields Expected to Stay in Double-Digit Territory

Average Middle Market Direct Lending Yields (Percent)

2. Emphasis on Asset Selection, Portfolio Construction

Of course, investors can only benefit from higher rates and asset yields if they can also limit losses. This underscores the importance of building resilient portfolios, rooted in strong upfront underwriting and appropriate structuring and maintaining active portfolio management. For lenders with scaled and diversified portfolios, we expect higher rates to more than offset a potential modest uptick in losses caused by borrowers struggling to meet increased debt service requirements.

For now, the economy remains resilient, and we think prospects are good for a soft landing. We also believe direct lending is well-positioned to withstand a modest recession. There may be pockets of stress and tighter liquidity for borrowers in select cases caused by higher rates. But we take comfort in the downside protection potential of senior secured loans executed at low loan-to-value ratios.

3. More Robust Deal Activity

The Fed raised rates by more than 500 basis points over a roughly 18-month span. It was hardly surprising, therefore, to see M&A volume decline. According to the London Stock Exchange, middle market lending volume for financial sponsor-backed companies fell 32% in 2023 from a year earlier.

Looking ahead, we expect the more recent stability in rates to cause the bid-ask spread between buyers and sellers of middle market companies to tighten, which should increase deal activity. Financial sponsors with ample dry powder will likely be on the lookout to deploy capital before the end of their funds’ investment periods. Meanwhile, sponsors with existing assets will be inclined to monetize their investments in order to return capital to investors. This should cause price expectations among buyers and sellers to converge.

4. A Bigger Opportunity Set

Banks’ multiyear retreat from middle market lending – a key driver in the growth of private credit – is likely to continue this year, opening up more opportunity for investors in direct lending strategies.

Thirty years ago, banks accounted for 75% of US leveraged lending. That figure has since been reversed, with nonbank lenders now commanding a 75% share. US banks are likely to continue to face pressures in 2024 amid lower deposits and as the implementation of new regulations approaches.

Not all banks are stepping back from leveraged lending, though. Some have entered the private credit space by partnering with established private lenders. This may offer banks a capital-efficient source of private loans. Private credit managers, meanwhile, can benefit from incremental deal sourcing and, in some instances, more capital for loans. When structured appropriately, these partnerships can provide incremental opportunity for direct lenders.

We’ve also seen large-cap borrowers tapping the private credit market for financing. With their scale, these borrowers can choose to borrow in the broadly syndicated loan market or from private lenders. This trend is still in its early stages and may expand the opportunity set for direct lenders.

Moving Forward

Even with yields likely to moderate from their 2023 peak, we think returns will exceed those seen in prior years.

Of course, some borrowers are likely to struggle with higher rates, so the key for investors will be finding a manager well-positioned to minimize losses. We believe direct lenders who maintain discipline and stay selective will be best suited to deliver strong risk-adjusted returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.