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Positioning portfolios for late cycle dynamics: Direct lending

Investor interest in middle-market direct lending has increased significantly since the early 2000s and continues to grow. The asset class is largely business-cycle agnostic and may offer opportunities to generate income during both economic contractions and expansions.

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Seeking income throughout the cycle with direct lending

Middle-market direct lending has evolved over the last 20 years, and many institutional investors increasingly view it as a strategic portfolio allocation. Their interest has been fueled by an appetite for floating rate income streams; the attractiveness of a senior secured creditor position; and a need for reduced correlation among their asset mix.

Direct lending is characterized by flexible and creative financing solutions that are unique to each opportunity. However, there are certain structural features that are common to most loans: security, structural seniority, floating rate pricing, contractual yield and amortization, financial covenant protections, and management access.

Additional direct loan features may include warrants or other equity-linked structures that potentially provide capital appreciation in certain situations. In aggregate, these qualities contribute to direct loans’ markedly different risk-return profile from conventional fixed income securities. Consequently, they may be a source of meaningful portfolio diversification and risk-adjusted return when added to stock and bond holdings.

Middle-market lending reshaped by secular forces

For most of the 20th Century, commercial banks were the primary lenders to small- and medium-sized enterprises (SME), but two major events — regional bank consolidation beginning in the 1990s, and the 2008–2009 global financial crisis — led to a decline in SME lending.

As banks retreated, non-bank financial intermediaries, funded by institutional investors (e.g., insurance companies, pension funds, endowments, and sovereign wealth funds), emerged to fill the void. Since the late 1990s, the U.S. lending landscape has changed dramatically, with institutional investors now originating approximately 84% of primary leveraged loan issuance, compared with 42% in 1999.

Navigating increased competition-and a late cycle

Direct lending has become an increasingly important part of the U.S. corporate lending landscape, and significant capital has been raised to meet the demand. This has led, in some cases, to a loosening in underwriting standards as lenders make accommodative decisions to increase volume. Against this backdrop, experience in direct lending throughout business cycles, deep industry expertise, and a fundamental focus on credit risk management are essential.

Allocations to private credit are rising

Allocations to private credit are rising

Source: BlackRock’s 2019 Global Institutional Rebalancing survey, January 2019.

Note: The bars show the proportion of investors surveyed that indicated a preference to increase, decrease or make no change to allocations to respective asset classes in 2019. The sample size by asset are as follows: equities (225); private equity (188); private credit (160); real estate (203); real assets (173). The private credit allocation intentions refer to responses among global fixed income clients.

Key takeaways

  • Direct lending is an asset class that has historically generated attractive, risk-adjusted returns through a variety of business cycles
  • Despite growing interest in direct lending, the asset class continues to provide opportunities to generate alpha.
  • Over the long-term, direct lending has consistently outperformed other income-oriented strategies on a risk-adjusted basis.

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