CJ Doherty
Welcome to the Lending Lowdown. I'm CJ Doherty, director of analysis at LSEG LPC. And today, we're gonna be focusing on the US direct lending market in what is our 24th podcast in the series. Private credit or direct lending has experienced huge growth in recent years and has changed the face of the loan market. Given that we're just over halfway through the year, I thought it'd be good to take stock of current conditions in the market and look ahead to what's in store for the remainder of 2024. And so, to shed light on all this, I'm joined today by Alex Gorokhovskiy, head of direct lending and venture debt at Deutsche Bank. Alex, it's great to have you here. Thanks for joining me.
Alexander Gorokhovskiy
I'm excited to be here. Thanks for having me.
CJ Doherty
OK, so uh to set the stage first it would be good to hear about Deutsche Bank's focus in the direct lending space. Can you give us a a quick overview here?
Alexander Gorokhovskiy
Of course, I'd be delighted to, I guess first and foremost, working for a regulated institution I have to start off with a disclaimer that I will be discussing my personal views and not that of DB's official position or that of our research group. I guess so to give additional context about my background. I've been a DB for 20 years now across a number of roles, predominately in sales and trading. And overseeing our corporate direct lending business for a better part of the last decade, more recently picking up the mandate for venture. I work in the group called private credit infrastructure, the team manages around $23 billion of balance sheet of bank capital today in US across 4 business verticals comprised of appraised asset, financial asset solutions, infrastructure and last but not least, the business that I oversee corporate direct lending and venture debt. We find that we're most impactful in the unitranche product for corporate direct lending transactions, but we have the flexibility to deploy capital and support businesses across capital structure and various industries both sponsored and not sponsored globally. We are balance sheet capital driven and and so we're not subject to the same capital raising cycles that some of the traditional private credit firms are, which allow us to be supportive at the time when most of the market starts to retrench. In recent times, really good examples of that: second half of 2022, we were super active in supporting businesses and during COVID.
CJ Doherty
Now let's discuss current market conditions and loan deal flow. How did the recent quarter go and how would you characterize current deal activity?
Alexander Gorokhovskiy
Evolving. The market is constantly changing and we're adjusting to accommodate accordingly. We are seeing some improvement, M&A. Certainly the deal volume that is in the market is picking up, which is not necessarily translating into execution the same way. A lot of the M&A is really constrained by seller expectations and what the buyers are willing to pay. At the same time, some of that bid offer is starting to moderate with stabilization and rates and sponsors and businesses generally looking to exit, whether they're public companies, corporate or private equity-backed. As I look at our pipeline over the year, it's the highest it's been since 2021, which is remarkable, but the quality is significantly diminished. So for the first time in a really long time, or probably ever, we're seeing a lot of the deals that are represented through the process, not ultimately check out through confirmatory diligence, which happened on occasion historically, but is happening more consistently today. While the direct lending fundraising activity has not really rebounded to its highs, there remains a lot of dry powder and and funds are being raised. At the same time, the new deal activity is as I alluded to, it is constrained and and so there is a supply and demand imbalance between the number of transactions that are available and the amount of capital that's pursuing them in the direct lending market. The deal structures naturally reflect that and you're seeing a lot more tightening in spreads and loosening of deal terms to make the solutions more compelling.
CJ Doherty
How would you describe the current dynamic of syndicated versus direct lending?
Alexander Gorokhovskiy
Healthy tension, healthy tension, to the benefit of the borrowers. It's a reflection of a well functioning market, and while we saw private credit refinancing a lot of term load, that transactions term loan B deals in prior quarters, we saw that those trends reverse in Q1 of this year where the term b market was taking out private credit Deals approximately 6 to one. Now that's moderated in the second quarter with private credit responding by offering more compelling terms to their borrowers and and protecting their their space. Large private credit funds will be able and correspondingly will look to do bigger deals and they will take the syndicated market head on.
CJ Doherty
OK, great. And and what about private credit versus, you know, bank direct lending and or bank partnerships, you know what are you seeing there?
Alexander Gorokhovskiy
A lot. I there've been countless announced in the last couple of months and it makes sense. Companies, whether sponsored or non sponsored, will consistently have a growing need for debt capital and that need increases over time. And it may sound like a bad thing because companies are taking an untenable amount of leverage. But, but that's not true. As economy grows, the GDP grows in nominal dollars, and correspondingly they're just more profitability and bigger businesses that require more capital. US GDP, for example, moved up from $20 trillion at the trough of COVID to over $28 trillion today. That's over 40% jump and that means the companies and the businesses are just much bigger and they will need to incur more indebtedness. You will need a really healthy credit market. Be it private credit, bank lending syndicated markets to fulfill this growing need and all these have and will continue to exist. Banks need to build out credit private credit infrastructure to support their clients, to offer that full solution. At DB we're privileged, privileged to have a long standing deep credit business. It takes years. Many teams working together and collaboration with regulators to establish. It requires a consistent underwriting process, established credit risk limits, controls, spending market risk, regulatory, accounting, finance, tax, legal compliance, reputational risks. Countless teams and I'm just naming a few. The JV structure is the fastest and the most efficient path to market and and so it's not surprising that we're seeing all these announcements and I expect we're going to continue to see more effort by the banks to do more of the same. It's hard to say if this model or a particular type of model or JV will be successful. It's important to have alignment of interests to have a successful outcome, that alignment needs to exist between the borrower or the originator, the underwriter, the asset manager and their investors. Borrowers will need to trust that ultimate managers of those funds will not cease to exist and will continue to support them over the life of the transaction and make good decisions benefiting all parties involved.
CJ Doherty
And let's talk about structuring now a little bit. How are you structuring deals in this higher rate environment? You know, what are your comfort levels for leverage and how aggressive is pricing?
Alexander Gorokhovskiy
Though the market around us constantly evolves, our underwriting doesn't change. For all its complexity, credit is simply an extension of capital, and its performance is driven by obligors' ability to repay that. That repayment is a function of asset value, which in the case of direct lending deals, is is enterprise value and and cash flow, ability to support that indebtedness. Our underwriting always centers around sustainability of those cash flows and margins and ability to push things like price, uh on the count of inflation, rising labor costs, materials, as well as sustain those cash flows peak to trough through economic cycle. That means that higher capex deals that are more cyclical will naturally warrant lower leverage, saying 3 and a half to 4 and half times. Whereas really large scale leading rule of 70%+ enterprise software business can incur much higher leverage and still create enough cash flow to repay debt. We're consistently underwriting to those trends and are not changing our underwriting approach. The dispersion is much higher than in the past, opportunity said seems to be pricing out somewhere in the 5 - 650 range versus a much narrow range in 2021, for example, where most of the deals we're doing it, we're 550 to 575 over.
CJ Doherty
OK, great. Alex, how are portfolios holding up, especially now that there's been a prolonged period of higher rates?
Alexander Gorokhovskiy
We're seeing the defaults overall in the market tick up a little bit from historically benign rates. That's true for private credit as well. Because of our underwriting methodology, we've been lucky and to date have been protected from some of these macro challenges and the portfolio continues to perform really, really well. Whatever challenges we have seen, they have been idiosyncratic in nature. I'll give you maybe 2 examples. In one instance, there was a business that was investing into growth, hiring for their sales and marketing organization, and it came at a time when some of their customers scaled back purchases. In that instance, we worked very closely with the company and the sponsor to ensure that the operations were right sized to match the current environment and the business was very quickly returned to profitability and sufficient cash flow. In another instance, there was a business that was more cyclical in nature and was operating at peak utilization and and profitability margin contribution and that was visible in understood at the time of underwriting. And so we opened up at much lower leverage attachment and despite deterioration, the business has adequate free cash flow today to support its capitalization.
CJ Doherty
Great. And so at last question for you then what are your expectations around direct lending deal flow in the remainder of 2024? You know, power pipelines looking now as we had further into the summer months.
Alexander Gorokhovskiy
The things always slowed down into the summer. I somehow found that we tend to be busier. There is some degrees of commoditization, which means they're going to be a lot of opportunities that are not going to fit that mold and generally, as I look at the year ahead, you see elections around the world and in US later this year, you're seeing the constant tension between inflation and and corresponding uncertainty with Fed actions or how that might impact economic performance. You're seeing geopolitical risks everywhere. That has real ramifications, not least of which on supply chains. There's consumer health that's ever evolving and generally sponsors are now focused on making differentiated investments as opposed to paying the highest multiple for the next best asset.
CJ Doherty
Great. And and that's all we have time for today, Alex. Thank you very much for sharing your insights and your outlook with us
Alexander Gorokhovskiy
Thanks for having me.
CJ Doherty
And thank you all for tuning in. I invite you to check out our direct lending news data and analysis at loanconnector.com. Follow us on X at LPC loans. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform.
