How to be a smarter credit investor and (possibly) find attractive risk-adjusted returns…

Now that Direct Lending has benefited from a significant influx of institutional capital, who is the new rising star in the credit universe?

Compressed pricing and weakened investor protections.

1. Pricing Pressure from Excess Capital Inflows

The success of Direct Lending has ironically sown the seeds of its current struggles. The significant inflow of capital into the space has led to intense competition among lenders, driving down yields.

Market Expansion: Direct lending (light blue) has seen substantial growth. Assets under management (AUM) by U.S.-based private credit managers reached approximately US$1.7 trillion in 2023, up from US$725 billion in 2018. During the same period, the broadly syndicated loan market BSL (blue line in chart below) reached a peak of US$1.4 trillion in September 2022 before experiencing a slight decline in 2023.3

Spread Compression: In a recent conversation4 with a very reputable U.S.-based Direct Lending manager, the dilemma became clear as they mentioned pricing trends in their evolving deal flow. A typical Uni-Tranche Direct Lending deal 24 months ago would pay SOFR+700 basis points (bps) while today the same deal only pays SOFR+425bps or 450bps. That is substantial price erosion.

In a recent outlook for Direct Lending Morgan Stanley concludes5 that over the past two years, spreads on new direct loans have tightened, largely due to improved risk sentiment and a resurgence in public capital markets. Despite this compression, the average liquidity premium in 2024 remained at approximately 178 bps, consistent with the average since 2018, resulting in total coupons of around 10%.6

Is a 1.9% annual yield difference adequate for investing in Direct Lending vs the Broadly Syndicated Loan Market?

Yield Differential Narrowing: As Lincoln International stated recently7, in Q1-24, the yield difference between Direct Lending and Broadly Syndicated Loans (BSL) narrowed further to 1.9%, a significant decrease from the historical average of 3.7%. This reduction reflects increased competition among lenders and a convergence in returns between the two markets.

2. Erosion of Covenants

Beyond pricing, perhaps a more concerning trend is the weakening of legal protections and covenants in direct lending agreements, as this directly impacts the downside protection of credit investors’ capital.

Rise of Covenant-Lite Loans: The prevalence of covenant-lite structures has increased notably.8 For example, in Q3 2024, 7.8% of loans reviewed included a ‘high water mark’ provision, up from 3.8% in Q2 and 4.8% in Q1.

High watermark provisions limit the effectiveness of lender protections (such as leverage ratios, interest coverage ratios, or minimum liquidity requirements) as they are temporarily turned off, only kicking in when the borrower’s financial condition deteriorates past a certain point. Many market participants told us that, as private credit transactions grow in size, the diminished maintenance covenants in larger Direct Lending loans increasingly mirroring the terms of broadly syndicated loans or bonds.

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What Does This Mean for Credit Investors?

The combination of lower returns and weaker protections presents a double whammy for investors. Direct Lending is no longer offering the same compelling risk-reward profile that once made it a standout in private credit portfolios.9

What is the Solution for Credit Investors?

While Direct Lending may now be less attractive than maybe a year ago , other private credit sub-asset classes are beginning to look more appealing. We are not suggesting that Direct Lending is a bad asset class; we believe it can still be an excellent investment, considering risk-adjusted returns. However, much of its attractiveness depends on timing. We cannot time the market, and in our view, no one should try to do so. However, we do believe there are clear signs when certain investments become unattractive—both in absolute terms (such as IRR or MOIC) and relative to other credit investment classes.

The professional credit investor will recognize that sustainable returns and capital protection can only be achieved through constant review of credit terms, market conditions, legal frameworks, and capital flows.10

At this moment, those factors are stacked against Direct Lending, and the asset class may have lost some of its shine, although many may not voice that publicly. The professional credit investor, however, will realize that there are new (potential) ‘crown jewels in the king’s treasure chest.

Introducing: Asset-Based Lending (ABL)

Asset-Based Lending (ABL) is a financing method in which businesses secure loans using their tangible and intangible assets as collateral. It offers strong diversification due to asset pools rather than single assets as security, along with significant structural protections, including heavily preferred amortization schedules. In any situation, as cash is generated,investors typically get their money back first.

What Exactly Is ABL?

Asset-Based Lending (ABL) has its roots in the early 20th century when manufacturers and wholesalers needed alternative financing to support operations beyond traditional bank loans. Initially, it was used by companies with substantial physical assets, such as inventory and equipment, to secure working capital. Over time, evolved to include a broader range of collateral, such as accounts receivable, intellectual property, private equity stakes, bank loan portfolios, and more

Today, ABL is a structured financing approach where businesses obtain specialized, tailored loans based on the value of their asset pool, rather than relying solely on the cash flow or creditworthiness of their operations. It is now widely used by companies in industries such as retail, manufacturing, and increasingly by financial services firms, including private equity firms seeking to borrow against existing and well-performing portfolios of assets.

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What is the Attractiveness of Asset-Based Lending (ABL) for Investors?

• Collateral-Backed Security – Unlike typical loans, ABL is asset-backed, meaning the lender has a direct claim on specific collateral such as receivables, equipment, intellectual property rights, or loan contracts. This significantly reduces downside risk and improves capital recovery in the event of borrower default.
• Stable and Predictable Cash Flows – ABL structures often involve recurring interest payments and early amortization (1st money out structures), making them an attractive source of steady income and a safe investment for investors, particularly in uncertain economic environments.
• Attractive Risk-Adjusted Returns – Compared to traditional fixed-income assets, ABL offers higher yields while maintaining a relatively low risk profile. Loans are typically over-collateralized and structured with protective covenants. Both features depend on the lender’s structural know-how, and only expert credit managers are able to offer attractive risk-adjusted returns to investors.
• Diversification and Non-Correlation to Public Markets – ABL investments are less correlated to stock and bond markets because their asset pools are individually valued.11 They are typically structured as portfolio deals with significant granularity, leading to strong diversification (risk mitigation) and stability (volatility reduction), especially during periods of market turbulence.

How Can Family Office Investors Gain Access to Asset-Based Lending (ABL)

ABL investing is primarily an institutional market, mainly due to the large ticket sizes, often ranging from several hundred million dollars to US$1 billion per transaction. As a result, only very large credit managers are active in this space, and they typically require significant investments to participate, often with minimum commitments of US$20 ‒ 50 million.

ABL deals require extensive expertise in two key areas: first, in accurately valuing specific asset pools, such as intellectual property, private equity stakes; and second, in structuring best protections for investors, while also ensuring that the ABL facility remains highly attractive to the borrower to secure favorable pricing.

In our view, it is essential to work with best-in-class credit managers to ensure effective execution in these areas. As an investor, you do not want to take on additional risk without being adequately compensated, nor do you want to be stuck in deals with delayed exits.

We have monitored deal evolution over many years and have successfully invested in the ABL asset class during that time.

As always, if you would like to discuss Asset-Based Lending further or share your experiences, please get in touch or leave a comment.