In our previous article, we went through various types of private credit strategies. In this article, we will explore “Direct Lending” as one of the forms of private credit. This guide will provide an in-depth look at Direct Lending, helping you make informed decisions as you explore this alternative investment space.
Direct lending is a form of private credit where non-bank entities, such as private debt funds, institutional investors, and DeFi protocols, provide loans to borrowers. These loans typically have fixed interest rates, and borrowers use the funds for various purposes, such as working capital, growth initiatives, refinancing existing debt, or funding acquisitions.
Growing Share In Global Alternatives Market
Direct lending has become increasingly popular among private credit investors seeking higher yields and attractive risk-adjusted returns. According to BlackRock Alternatives’ recent report (Feb 2023), the factors driving direct lending’s growth are expected to persist, owing to its attractive return profile, loss rates that are comparable to (or even better than) public markets, and diversification benefits for traditional investment portfolios.
In the following chart, you will see that private credit (a.k.a private debt) as an asset class has been rapidly rising since 2007, representing 12% of the global alternatives market.
Source: BlackRock Alternatives’ Report
Among the US$1.3 trillion private credit market, the most prominent category is Direct Lending which represents 44% of all private credit investments.
Source: BlackRock Alternatives’ Report
As with any investment, Direct Lending comes with its unique set of advantages and drawbacks. Understanding these aspects will allow investors to make informed decisions about whether direct lending is the right investment choice for their specific goals and risk appetite.
Pros of Direct Lending
Higher yields: Direct lending can offer higher yields compared to traditional fixed income securities, such as government or corporate bonds, due to the illiquid (see explanation below) nature of these loans and the lack of access to traditional bank financing for borrowers.
For instance, Bluejay’s first and second loan pools allow investors to invest in a direct lending fund for SMEs in Singapore, Thailand, Vietnam, and Indonesia, yielding 7% p.a. on SGD, notably higher than the 3.03%-3.21% p.a. offered by Singapore Savings Bonds (as of May 2023).
Diversification: Investing in direct lending allows investors to access a diverse range of borrowers and industries, which can help diversify their investment portfolios.
Investors seeking diversification could consider investing in credit funds that lend to a diverse portfolio of businesses spanning multiple sectors and markets. Alternatively, when lending directly to individual businesses, investors can diversify their portfolio by allocating funds to companies in various industries and geographic locations.
Regular income stream: Direct lending investments often provide a regular income stream through periodic interest payments, making them suitable for investors seeking income generation.
For example, an investor could invest in a direct lending fund that finances SMEs in various industries. The fund generates income through interest payments from its portfolio of loans and distributes this income to its investors on a quarterly basis, providing the investor with a regular income stream.
Bluejay offers two repayment options: bullet loans and amortized loans. With bullet loans, investors receive regular interest payments and a lump sum principal repayment at the end. In contrast, amortized loans provide investors with periodic payments consisting of both principal and interest portions.
Cons of Direct Lending
Illiquidity: Direct lending investments are often illiquid, which means that they may be difficult to exit or sell in secondary markets.
For instance, an investor with a substantial allocation in a direct lending fund focused on small business loans may struggle to quickly exit their positions if they cannot find a buyer in a timely manner.
This lack of liquidity may make direct lending less suitable for investors with short investment horizons or who may need to access their capital quickly.
No standardised reporting: Direct lending investments may lack the standardised reporting that traditional fixed income securities offer, which can make it more challenging for investors to assess the performance of their investments.
For instance, an individual investor who directly lends to a manufacturing company in Asia as a component of their investment portfolio might face challenges in assessing the investment’s performance. This is because the company’s periodic financial updates may lack consistency and the detailed information typically found in traditional fixed-income securities.
Consequently, the non-standardized reporting can hinder the investor’s ability to accurately evaluate the company’s financial health and the performance of their direct lending investment.
Due diligence requirements: Direct lending requires investors to conduct thorough due diligence on borrowers and their creditworthiness. This process can be time-consuming and may require specialised knowledge or resources.
For instance, an investor evaluating a direct lending opportunity with a technology start-up must carefully examine the borrower’s creditworthiness, financial health, and growth prospects. This necessitates conducting in-depth research, seeking advice from industry experts, and analyzing relevant market trends. While the due diligence process can be both time-consuming and demanding in terms of resources, it is essential to reduce potential risks linked to the investment.
Risks in Direct Lending
In addition to the pros and cons of Direct Lending, it’s essential for investors to understand the various risks associated with this investment type. Being aware of these risks will enable investors to make informed decisions, develop suitable risk management strategies, and maximise their potential returns in direct lending investments. In this section, we’ll outline the key risks involved in direct lending.
Credit risk: The most significant risk in direct lending is credit risk — the risk that a borrower will default on their loan obligations. To mitigate this risk, investors should conduct thorough due diligence on borrowers and maintain a diversified portfolio of loans. Do have a look at some key areas for investors to note when they’re assessing private credit deals.
Interest rate risk: Direct lending investments may be exposed to interest rate risk, particularly if the loans have floating interest rates. Changes in interest rates can affect the value of these investments and the income they generate.
Economic and market risk: Direct lending investments can be sensitive to economic and market conditions. Economic downturns or industry-specific challenges may increase the likelihood of borrower defaults or reduce the value of the collateral securing the loans.
Concentration risk: Investors who concentrate their investments in a single borrower or industry may face higher risks if that borrower or industry experiences financial difficulties. Diversification across borrowers and industries can help mitigate this risk.
Regulatory risk: Changes in financial regulations can impact the direct lending market, potentially affecting the availability of investment opportunities or altering the risk profile of existing investments.
How Is Direct Lending Different From Other Forms of Private Credit
Direct Lending differs from other forms of private credit in several ways. Here are some key differences between direct lending and other private credit strategies:
Target borrowers: Direct lending typically focuses on providing loans to small and medium-sized enterprises (SMEs) and middle-market companies that may have limited access to traditional bank financing. Other private credit strategies, such as distressed debt, mezzanine financing, or special situations, target a broader range of borrowers, including larger companies, businesses in financial distress, or those undergoing significant transitions.
Loan structure: Direct lending often involves senior or subordinated loans with customized terms to fit the borrower’s specific needs. Other private credit strategies can include more complex financing structures, such as mezzanine loans with equity conversion features, asset-backed loans, or debtor-in-possession (DIP) financing.
Risk and return profile: Direct lending generally offers a lower risk profile compared to other private credit strategies, as it focuses on providing secured or senior loans with priority in repayment (Refer to our 101 on debt structure here). This results in lower potential returns compared to more aggressive strategies like distressed debt or special situations, which involve higher risk but offer the potential for higher returns.
Investment process: Direct lending often involves a proactive and relationship-driven approach, with lenders working closely with borrowers to structure loans and monitor performance. In contrast, strategies like distressed debt or special situations may involve a more opportunistic approach, focusing on identifying undervalued or dislocated assets in the market.
Purpose of financing: Direct lending is often used to finance working capital, growth initiatives, or acquisitions. Other private credit strategies can serve more specific purposes, such as funding management buyouts, recapitalizations, refinancing existing debt, or providing rescue financing to distressed companies.
Always Perform Due Diligence
Direct lending can offer attractive risk-adjusted returns and diversification benefits for investors seeking alternative investments. However, it’s crucial to be aware of the associated risks and challenges. Investors should conduct thorough due diligence, maintain a diversified portfolio, and stay informed about the evolving regulatory environment to navigate the world of direct lending successfully.
When you are assessing opportunities available to you on Bluejay.finance, always check out the information pack available in the data room to uncover the information mentioned above.