As Alternative Lending Goes Mainstream, 3 Things You Need to Know

Alternative lending isn’t looking so alternative anymore.

Alternative lending, also known as direct lending, has exploded in recent years as traditional banks have pulled back on lending to middle market companies in the wake of the financial crisis and increased regulation. Alternative lenders — private equity funds, hedge funds, insurance companies, asset managers, and other institutional investors — have rushed to fill the void, attracted by relatively strong returns and consistent revenue streams.

Once a backwater, the total sum of outstanding middle market direct loans in the U.S. is estimated to be $910 billion, according to private equity firm and credit provider Ares Management. The market is expected to continue to grow as private equity firms and others raise billions of dollars in capital for direct lending.

“Alternative lenders have found there is tremendous appetite among borrowers to fill in the gap between bank debt and going out to the equity markets and giving away ownership of the company,” said Guy Gribov, a partner in V&E’s Finance practice.

With more capital flowing into direct lending, competition is heating up, creating a ripple effect for lenders and borrowers. While alternative lenders used to enjoy more negotiating leverage simply because there was a limited supply of these types of loans, borrowers increasingly find themselves in the driver’s seat.

As the alternative lending landscape shifts, Gribov and Mike Bielby, a fellow partner in V&E’s Finance practice, shared three things lenders and borrowers need to know:

Greater risk means more work

Asset managers are increasingly focusing on direct lending because they see the potential for higher yield than other asset classes. Nonetheless, execution is critical, and it starts with a careful assessment of credit risk.

Analyzing a company, its market, and its financials are all the more critical for nonbanks because of the nature of the borrowers. Companies that turn to more expensive direct loans generally do so because they do not meet the underwriting standards of traditional banks.

“This is not a cookie-cutter type of deal,” Gribov said. “Each borrower presents unique risks and challenges that need to be understood and assessed.”

“There’s a reason that this type of borrower doesn’t qualify for bank financing. Either the borrower, its business, particular assets, or the desired loan amount doesn’t allow them to qualify,” Bielby added. “By definition there is more risk, and although some of that risk is compensated for in pricing, or sometimes with equity kickers, you need to structurally mitigate against it. Otherwise those risks will come to fruition.”

Borrowers, in turn, should expect more scrutiny and more monitoring from an alternative lender than they might experience with a bank. For some borrowers, that might feel intrusive. The important thing is to anticipate the oversight and develop a level of trust with the lender.

Flexibility is key

Alternative loans by definition are more flexible than bank loans. Unlike regulated banks, nonbanks have more discretion as to how much debt their borrowers take on and where their loan is held in a borrower’s capital structure.

In an increasingly competitive direct-lending marketplace, being willing to go the extra mile to structure creative loans is one important way alternative lenders can stand out from their peers.

“What we’ve seen is lenders that are more willing to be flexible in terms of how they structure their capital, and those who address the borrower’s leverage concerns, or their accountant’s concerns, have been able to win more mandates,” Gribov said. “Conversely, borrowers that are willing to be flexible in response to lender concerns are more likely to end up with a transaction that best suits them.”

Reputation matters

Increased competition in the alternative lending space means borrowers have many more options than they had in the past. As a result, they have more leverage in negotiating favorable rates and loan terms.

But choosing the right lender is much more than an economic decision. Learning about an alternative lender’s reputation and how it manages its relationships is an important part of the decision-making process.

“You want to understand who your lender is before you become wed to them in a credit facility that is going to last five to ten years,” Bielby said.

The consequences of choosing the wrong lender can be highly disruptive to a borrower.

“The lender might put pressure on you to refinance at a very expensive premium, or to raise much more expensive equity to solve a problem,” Gribov said. “They could put pressure on you to give up more ownership to them of the company, versus somebody who is more solution-oriented and whose goal is to protect a particular yield, rather than try to get more yield.”

Lenders, in turn, can use reputation to their advantage. Demonstrating a track record of solid relationships with borrowers is one more way alternative lenders can gain a competitive edge.

“Alternative lending has grown to such an astounding size and the number of players has grown to such a degree, that reputation and relationship are more important than ever,” Bielby said. “It’s no longer just about offering the lowest rate. It’s about developing a reputation that you are focused on working with borrowers and finding solutions.”