Direct lending became more popular after the most recent financial crisis and is now normality in the US especially. Strict rules and requirements led traditional banks to reduce lending to businesses, creating a massive opportunity for direct lenders.
In order to grow their businesses, small and medium enterprises are acquiring loans directly from lenders, without middlemen. These lenders can be asset management firms or wealthy investors.
The Downside of Traditional Banking
The Harvard Business School has stated that following the economic slump in 2008, small business loan approvals have reduced by 21%. In addition to more stringent guidelines, the ROI (return on investment) for loans given to SMEs no longer make financial sense to banks as opposed to loans given to larger corporations.
This left a gap in the market for alternative lending opportunities including direct lending. SMEs seeking to fund their activities and grow their businesses have taken on these alternative options.
The Growth of Direct Lending
Asset managers filled the lending void when direct lending came onto the funding scene. After that crowdfunding and P2P (peer to peer) lending platforms came into play. Asset managers are more focused on bigger deals while the others have come in to provide funding for smaller loans.
In 2017, direct lending in Europe raised about $22 billion and by 2020 it is most likely to surpass $1 trillion on a global scale.
Direct lending offers attractive high returns for investors and they plan to invest even more money in 2019 than before. Assets in direct lending industry amount to almost $ 770 billion. The US is ahead of the rest of the world with a market share of 61%. Europe is following closely behind.
In Europe, very few credit funds existed before the economic downturn but they increased significantly afterwards. They have continued to provide bigger amounts of funding over the years, competing with traditional banks.
Direct lending is attractive to investors because they achieve high yields with better security. Such investment benefits insurance firms and pension funds with regular income distribution and capital gains over a long period of time.
Products in Direct Lending
- First Lien; these loans are the first to be paid and are priced using a floating rate coupon.
- Second Lien; this loan is secured but is second priority aft ether the first lien
- Unitranche; This is a top source of funding with almost limited risk
- Subordinated/Mezzanine; this is a fixed rate loan that is unsecured.
Benefits of Direct Lending
Asset management firms acquire a lot of money from investors. Lenders are able to offer huge checks to fund businesses for a single deal. Investors can also join forces to meet a large loan requirement.
Direct lenders offer more flexibility than traditional banks. They are more willing to take on some of the business risks. They offer products that suited to your particular business needs and their repayment schedules and terms are also flexible.
Lenders cover the loan process, see here, from start to finish without any intermediaries. This means the process is efficient because approval and borrowers wait for a short time to receive the funds.
Personal details are kept confidential without risk of sharing them. Middlemen, on the other hand, are likely to give your personal information to potential lenders who contact you to borrow more money.
The relationship between the lender and borrower is a key component that is easily fostered with direct lenders through constant communication and efficient problem solving as opposed to banks.
Whereas ordinary banks end up taking over businesses that are struggling to pay back, direct lenders allow companies to maintain control over their business while providing financing solutions and allowing repayment in a flexible manner. This is especially crucial for family-owned enterprises that have emotional attachments.
Other benefits include;
- Frequent reporting, lender protection and higher amortization
- Low volatility in comparison to liquid assets
- Floating rates with higher yields
- Equity cushion of 50% and more
Qualities of Direct Lenders to Look Out For
Larger experienced lenders are able to thoroughly evaluate business and make informed decisions before making an investment. The presence in a wide geographical area indicates that lenders are able to provide diversified products and customized solutions. Also, there’s assured commitment.
- Access to Funds
The ability to easily access capital means that lenders can manage large requests for funding. Some of them are able to achieve that through their partnerships with banks.
- Lasting Relationships
New players in the market are likely to have poor quality partners and less trust. Those that have been on the scene for years and have built a reputation and relationship are trusted more because of their knowledge, experience and credibility.
- Credit Competency
The ability to accurately analyze a company’s practices and financials before engagement is a crucial factor. This information provides a clear picture of a company’s future performance.
- Portfolio Management Strategy
Regular and transparent communication with borrowers provides indicators for problems or opportunities that may arise. This helps with developing a solid portfolio. A portfolio management strategy that monitors an investment over its lifetime produces maximum benefits.
- Efficient Structuring
Lenders that put emphasis on proper structuring of loan documents and covenants are more reliable. The backbone of these successful structures is effective operation management and modern infrastructure.
- Track Record
A tried and tested system that delivers results is imperative when looking out for fund lenders. Previous records that demonstrate the ability of the lender to perform through several credit cycles is key.
Risks of Direct Lending
- In the beginning, lenders focused on credible companies that were too small for banks to get an ROI from. Now, more lenders are offering high-risk loans to businesses that financially crumbling. This is an indication of the competitive market.
- Lenders operate without regulatory supervision is a risk to borrowers.
- In case of an economic meltdown, new lenders with low-quality loans will collapse, causing a problem for their borrowers
Before Lending to Businesses
When deciding to lend, direct lenders should look out for the following factors;
Increasing Rates; Lenders must test if potential borrowers will stay afloat in case of rising rates and still be able to make repayments.
Exposure; Lenders should assess their portfolios and discover the kind of borrowers or investors they have and determine if they should diversify.
Negotiation; Due to competition, borrowers now have a large pool of lenders to choose from. This reduces the interest rates they should charge thus decreasing their earnings. This requires that they negotiate independently to provide acceptable and workable rates.
At a time when traditional banks turned businesses away, direct lenders stepped in and provided the much-needed funding for them to grow and expand their activities. Direct lending is not going anywhere due to their flexibility, convenience, the rising number of investors and the constant demand for funding. However, they are likely to have a continued partnership with banks.
Direct lending should be viewed as a long-term opportunity and not a short-term investment. Low unemployment rates, increased earnings and strong major economic factors indicate that America is favorable for direct lending.