The outlook for direct lenders remains strong heading into 2021 given their increasingly critical role in the M&A value chain and proven ability to provide capital in various market conditions, including periods of heightened volatility. We expect the larger market presence established by direct lenders in 2020 to expand further next year and beyond.

In order to better understand how the direct lending market will look next year, a brief review of its evolution and performance during the turbulence of 2020 is warranted. After rising in prominence as a source of debt capital for middle-market M&A transactions in the decade since the Great Recession, direct lenders – the largest players in the fast-growing private credit market – entered this year well positioned as an alternative to traditional bank lenders, particularly for private equity borrowers.

During the COVID pandemic’s initial period of market turmoil in the spring, direct lenders served as a financing lifeline to sponsor owners and acquirors, completing a significant (albeit reduced) number of deals even as M&A transaction flow dropped to historically low levels. Through the summer, the direct lending market remained more accessible for M&A financings than the public leveraged finance markets.

Direct lenders have provided further evidence of their attractive value proposition by closing on a substantial number of transactions throughout the second half of this year in support of clear improvement in the M&A market. With the bar for new deals remaining high, Q4 has maintained a healthy pace of completions even with certain funds becoming more selective upon nearing their 2020 deal quotas.

Direct lenders will continue to participate fully in the M&A revival. The healthier backdrop for deal making includes a recovering economy, a powerful rally in the equity markets, and positive vaccine news. The prospects of better conditions ahead have caused private equity firms to re-engage a large number of previously delayed sale processes. Backed by $1+ trillion in dry powder, financial sponsors have resumed their pursuit of acquisitions following an assessment of COVID’s impact on their portfolio companies and stabilization in the credit markets. In view of the factors noted above, direct lenders are poised to continue to deploy ample capital in sustaining the M&A market’s momentum.

We expect direct lenders to gain more prominence in the M&A landscape during 2021. Dry powder for private credit funds entered Q4 at an all-time high. At the same time, unallocated capital is at peak levels for private equity firms after the COVID-related slowdown in buyouts, suggesting a busier year ahead for sponsors in need of M&A financing. Based on the high value that private equity firms ascribe to expedited execution, direct lenders are primed to support this activity. Furthermore, the relative return profile of private credit should continue to draw allocations from investors hungry for yield due to the low interest rate environment in the U.S. and Europe.

Direct lenders are well positioned to complete deals in the middle market as well as upmarket over the next year. The core middle market will remain the bread and butter for direct lenders due to the appeal of flexible mandates and certainty of close. As the direct lender market opportunity has expanded over the past two years, we have seen the emergence of “mega-tranche” transactions involving capital commitments exceeding $500 million at terms competitive with syndicated loan packages, including two 2020 loans in the neighborhood of $2 billion.

Based on a recent shift in the use of proceeds, we expect direct lender activity to focus more on larger deals such as LBOs in 2021. From March through August, direct lenders prioritized financing add-on acquisitions, reflecting the realities of a challenged M&A market as well as diminished appetite for bigger holds. While add-ons remained prevalent in recent months, the pace of LBO financings has nearly doubled since September relative to the preceding six months. “Our current pipeline includes unitranche financing for credits with EBITDA up to $75 million,” commented Anne-Marie Peterson, Head of Debt Advisory for Baird. On its last quarterly conference call, Ares Capital noted that the average EBITDA of companies in its new deal pipeline was about twice the year-ago level, underscoring the shift toward larger financing opportunities that is expected to extend through next year.

While the direct lending market should be accessible to all borrowers entering 2021, conditions could remain more bifurcated than normal in the first part of the year. Direct lenders are likely to continue to focus on COVID-resilient credits at the start of the year based on the potential for another pandemic-driven economic dip in early 2021. In addition, direct lenders are maintaining high standards for prospective deals and loan packages due to the need to balance ample opportunities with execution considerations given their finite resources.

Expansion of debt capital sources should translate to more borrower-friendly terms on a widespread basis in 2021. For high quality credits, leverage (often up to 6x) and pricing on recent deals are near pre-COVID levels due to intense competition among direct lenders and banks, whereas less favored businesses are still facing premium pricing and reduced leverage. “Our Debt Advisory team is seeing pricing as tight as L+550 bps in selected new issue LBOs for strong sponsors with healthy equity,” added Peterson. As the rollout of vaccines improves the economic picture deeper into next year, we anticipate broader participation among lenders, including from selected BDCs contending with challenged portfolio companies during much of 2020. Loan pricing should also reflect continuation of low yields for other debt-based asset classes.

Prospects for direct lenders are bright over the longer term. Preqin forecasts assets under management for private debt to increase an average of 11%+ per year to $1.4 trillion in 2025. According to a recent investor survey conducted by Preqin, 67% of private credit investors expect their allocations to increase by 2025, well above fund manager plans for other alternative asset classes such as real estate, natural resources, and hedge funds.

While improved fundamentals in the credit markets are fueling an M&A upturn, today’s M&A deals still require carefully choreographed financing that often features direct lenders. Baird Global Investment Banking frequently contributes to the successful sales of companies by developing a highly curated group of lenders that can offer financing on competitive terms after extensive education and due diligence. “Our integrated team’s considerable familiarity with the direct lending market has helped us structure financing packages that have proven critical to delivering excellent outcomes for our clients on sell-side M&A advisory engagements,” noted Mike Lindemann, Co-Head of North American M&A for Baird. “For example, Baird advised Sonny’s Holdings in its August sale to Genstar Capital, with our Debt Advisory group leading a customized acquisition financing process that resulted in a committed debt financing by direct lender Owl Rock Capital.”

Baird has helped many clients assess optimal financing solutions in support of M&A transactions and recapitalizations. We expect direct lenders will play an increasing role in the M&A market in 2021 and beyond given their growing scale and flexibility. Please reach out to Baird’s Debt Advisory team to discuss market dynamics in further detail.