Private Credit Loan Transactions

By: M. Shams Billah, BARNES & THORNBURG LLP, NEW YORK

This article discusses guidance for borrowers and private equity sponsors entering into private credit loans with nonbank lenders in the middle to  lower-middle market space. 

The article also discusses the background and benefits of private credit transactions as compared to public credit, as well as best practices for approaching the private credit market, key negotiation points, and recent market trends.

Private Credit vs. Public Credit

Private credit (also known as direct lending) has certain distinct characteristics that enable it to be a strong value proposition compared to public credit for market participants looking to incur loans. Private credit direct loans are provided by nonbank lenders, often on a bilateral basis or in a small club deal, to borrowers directly, rather than through a widely syndicated process run by commercial banks. These types of loans are not publicly traded, although there have been recent efforts to create a platform or exchange to allow for such trading. This is in contrast to public credit syndicated loans and bonds that trade in debt capital markets. The greater reliance of public credit on public markets is part of the reason for the recent exponential growth of private credit and the related benefits that private credit has to offer as further discussed below.

Recent Rise in Private Credit Transactions

The rise in private credit transactions occurred following the financial crises of 2008 when public debt markets tightened and essentially closed up and regulations were introduced through the Dodd-Frank Act that severely hindered the ability of banks to provide leveraged loans to middle-market companies. That is when private credit funds formed to fill the gap created by the shrinkage in traditional bank lending. Portfolio companies of sponsors and founder-owned small to mid-market companies, each of which were squeezed out of the traditional bank debt markets, turned to the private credit market, which was not subject to the same regulatory requirements of traditional banks.

Benefits and Downsides of Direct Lending

The accelerated rise of direct lending is in part due to the following unique features of direct lending transactions.

Benefits of Direct Lending

Certainty and Speed of Execution

As mentioned above, direct loans are either bilateral facilities or closely held by a small club of lenders. This is in contrast to broadly syndicated loans, in particular in the term loan B market where loans are held by hundreds of different funds and lenders. The bilateral or club nature of direct lending transactions allows direct lenders to be more nimble and often faster in closing deals and providing responsive, flexible, and bespoke solutions to the needs of borrowers and private equity sponsors. This is one of the reasons sponsors and first-time borrowers often turn to and prefer nonbank lenders to finance their transactions.

Non-reliance on Public Markets

As mentioned earlier, private credit is less affected by public market price volatility. The reason for this is that direct loans are usually held for investment through the tenor of the loan and are not traded, unlike broadly syndicated loans and corporate bonds that trade frequently on public markets. This lack of reliance on public markets allows borrowers and sponsors to feel more comfortable that their financing windows are not too affected by macroeconomic shocks, like the COVID-19 pandemic, during which private credit lenders continued to provide credit to the market in a resilient manner. In addition, lenders in the private credit market do not have to consider as heavily what the market may accept for terms and hence are not subject to market flex provisions as much.

Downsides of Direct Lending

The downsides of direct lending are often offset by the benefits noted above. More importantly though, most middle-market companies are not in a position to access public bonds and so the issues noted below are typically not relevant for middle-market companies. Some of the downsides of direct lending compared to public corporate bonds are addressed below.

Floating Rates

Unlike bonds that are primarily fixed interest rate instruments, private credit debt often has an interest rate composed of a floating rate (typically tied to a benchmark such as Secured Overnight Financing Rate (Term SOFR), often with a rate floor) and a fixed margin rate. Many loans also have a variable interest rate grid, which allows the fixed component of the interest rate to change based on pre-defined thresholds such as a leverage ratio. While borrowers may not prefer floating interest rates, this grid methodology can be attractive to borrowers because it allows the interest rate to adjust to positive (but also negative) changes to the credit risk profile of such borrower without the need for renegotiations or amendments in the future.

Covenant Heavy

Unlike unsecured high-yield bonds, private credit loans are typically first lien or second lien facilities secured by substantially all of the assets of the borrower group and have a number of covenants to protect such collateral. In general, these loans have a lot more covenants, including financial maintenance covenants, that provide strong structural protections to lenders much to the chagrin of borrowers compared to covenant-lite public debt facilities or bonds. The extensive set of covenants in private credit loan transactions typically results in lenders having a greater say in the company’s affairs, especially during difficult financial times and restructurings.

Higher Premiums/Fees

Although direct loans have shorter maturities of five to six years compared to long-dated corporate bonds, direct loans are often repaid or refinanced prior to maturity, but at a cost to borrowers. In such situations, nonbank lenders often earn additional returns in the form of call protection or amendment fees (which occur less so with bonds).

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Predictions Looking Forward

Lending activity in the middle market is likely to continue the upward trend we have seen thus far for the first half of 2023. There is ample dry powder to be deployed and lenders are looking for opportunities to put it to good use in the second half of 2023, which would be promising for borrowers and sponsors looking
to tap into the private credit direct lending market. However, the previous flexibility afforded to borrowers will likely continue to fade and loan agreements will continue tightening up and be more lender favorable. Lenders will be encouraged to continue this trend because of the increase in distressed situations that they may find in other parts of their portfolio. Anecdotally, the first half of 2023 has seen an uptick in distressed and special situations, which we suspect will likely continue into the second half of 2023. 

M. Shams Billah is a partner in the corporate department of Barnes & Thornburg. He leads the private credit team in New York and helps lenders and borrowers negotiate and close complex U.S. loan agreements and indentures for loans and bonds ranging between$1 million to over $10 billion.

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