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Hard hit direct lenders still set to beat rivals, Stepstone says

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Direct lenders should outperform their competitors in the leveraged loan and junk bond markets despite investing in some of the sectors worse hit by the coronavirus pandemic, according to advisory firm Stepstone.

In an insight into the opaque credit class, the private markets investment management firm analyzed around 4,700 direct lending deals. The report concluded that the industry should fare well compared with its peers, but that loans to mid-sized European companies remained vulnerable to fall-out from Covid-19.

Stepstone’s report states that direct lending’s higher cash coupons, more stable returns, illiquidity premium, and better capital recoveries from deals gone wrong will help the sector weather the crisis. But the broad endorsement of the industry’s health does not mean that all investors will be rewarded equally.

Stepstone partner Marcel Schindler told Bloomberg News there will be huge differences in the performance of different credit managers. Lower quality investments and inadequate diversification are likely to be the causes of future problems.

“The spike in defaults and covenant breaches in the mid-market versus the syndicated market does not bother us, because documentation is so much tighter in the mid-market,” said Schindler. “Just one covenant makes a huge difference in terms of outcome.”

The non-bank lenders’ exposure to the fallout from the pandemic is driven by having made more loans to consumer discretionary businesses, which are more likely to be mid-market in size.

That same mid-market focus is also the source of their likely longer-term out-performance, according to Stepstone. Loan terms for mid-market business include both better protections for lenders and higher interest rates.

Direct lending has enjoyed a decade-long bull run that brought private debt overall to a total of more than $800 billion in assets under management globally. The pandemic shutdowns and the recession that follows marks its first real test as a substantial asset class of its own.

Bloomberg News
Leveraged loans Corporate finance CLOs Europe
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