Security, please August 2022 | Number 189 – The rise of private credit in leveraged loans: a taste of fund financing? | Cadwalader, Wickersham & Taft LLP

[author: Chris van Heerden]*

Private credit funds are making their presence felt in the leveraged loan market. Recent transactions illustrate the scale that direct lenders have achieved, allowing these managers to compete directly with banks. Earlier this month, a group of private lenders provided a $2.5 billion unitranche facility that facilitated the acquisition of Avalara Inc. by Vista Equity Partners, the latest in a series of lending transactions to large capitalization that have been made outside the banks.

Private credit groups bypass the extensive loan syndication process used by banks and are therefore able to execute faster with greater pricing certainty. The concentration of financial firepower within a small group of institutions gives them greater power to negotiate better credit documentation terms than would be the case in a typical bank syndication. In addition, transaction size is no longer clearly the barrier to entry that it once was.

Banks are responding by allocating the balance sheet to hold loans and raising internal funds for direct lending. These measures are intended to streamline closings and remove syndication price flexibility. However, a large inventory of unsold committed loans and large anticipated write-downs prevent banks from being more competitive. A Reuters article published this week cites estimates that US and European banks could experience losses of $5 billion to $10 billion on leveraged loans over the next few quarters.

According to data from Preqin, private credit assets under management totaled $1.21 trillion at the end of 2021, and could more than double to $2.69 trillion by 2026. A loss of market share in the market leveraged loans can cost banks a significant amount of fee income, but also means the loss of an important connection point for advisory, trading and other income from financial sponsors.

From a fund financing perspective, developments in the broader lending market illustrate the growing importance of non-bank lenders. We see some implications for the fundraising market:

  • Private credit funds will become a more important source of capital for the fund financing market in the coming years. In the United States, progress has been slow but should accelerate.
  • Growth in assets under management, significant underwriting resources, larger fund sizes, a running clock on deployment windows and diversification of strategies are all trends in place that are likely to support more private credit lending in the fund financing.
  • This growth is likely to manifest itself primarily in NAV lending where lending spreads better align with the cost of capital of private credit.
  • Banks will continue to play an important role in the underwriting line market where their ability to meet liquidity needs cannot be matched with funds primarily due to differences in the cost of capital.
  • Banking regulation, which often turns out to be pro-cyclical, also seems on track to continue to drive capital formation towards less regulated institutions.
  • In funding funds, the relationship with these funds is more likely to be collaborative. The speed of execution and market price dynamics of leveraged loans do not impact fund funding and should allow for mixed loan groups.
  • Finally, banks could become more sensitive to the extension of subscription financing to funds which would then compete directly with them for lending activities and could instead become strategic in the selection of funds with which to partner.

*Director | Fund financing

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