Is now the time for direct lending and distressed debt?

56% and 43% of investors are poised to target direct lending and distressed debt

As experts debate the likelihood of a recession, it's important to understand what private debt has to offer. Over the last ten years, private debt has become a $1tn asset class. Aggregate capital raised reached $56.5bn in Q2 2022, exceeding the previous two quarters which raised $40.4bn and $50.8bn, respectively. But how can we know which strategy is the best fit? More importantly, how have these strategies behaved in varying markets? 

Why direct lending and distressed debt?
Private debt encompasses six main strategies with various subcategories, the most prominent of which are direct lending and distressed debt. As of 2021, both accounted for 65.4% of the private debt market combined and maintained the largest hold on investor allocations. Despite their base similarities, these strategies have varying characteristics and manners. 

Direct lending
Direct lending is the biggest strategy in private debt with multiple subcategories, including senior debt, unitranche debt, junior, and blended debt. Direct lending in North America hit its peak in Q4 2021 at $27.9bn in aggregate capital raised. Although Q2 2022 missed out on similar highs, it managed to hold strong at $19.3bn. 56% of investors have indicated that they will target direct lending investments in the next twelve months, a noticeable lead compared with the 43% selecting distressed debt, and 48% mezzanine. Direct lenders’ availability during these times of geopolitical turmoil and volatile market conditions may be helping them win market share.

While the usual trope is higher risk, higher reward, it may not hold true in every case (Fig. 3). For funds with vintages between 2015 and 2018, direct lending performance remained consistent, with a standard deviation net IRR of just 8.3%, significantly lower than that of distressed debt which posted 20.2% (Fig. 3). Despite being less volatile, direct lending’s performance was not so dissimilar to that of distressed debt. This means the strategy virtually offers LPs the same median return but with far less variance. The average net IRR for direct lending was 9.6%, compared with distressed debt which was 10.6% (Fig. 3).  As direct lending has the potential for comparatively stable returns, LPs must consider in which conditions these returns will most likely occur.

A blast from the past
Direct lending saw its best performance in 2009 when the median net IRR reached 13.58%, a record high (Fig. 4). Inflation in the US fell drastically that year from 3.8% annually in 2008 to -0.35% in 2009.  Assuming these conditions are a reasonable indication of the strategies’ success, direct lending certainly has potential in the current market. 

According to the estimate released by the Bureau of Economic Analysis, the US GDP decreased by 1.6% in Q1 2022. This drop may indicate a potential recession, which may prove advantageous for direct lending. On the other hand, the federal fund rate, as well as interest rates, are on the rise. In 2022 alone, the federal fund rate increased from 0.08% in 2021 to 1.75% in July. Inflation has also accelerated this year to 4.6% annual growth, the highest since 1982. While conditions may not necessarily be ideal, direct lending’s stable disposition could prove attractive in a turbulent market.

Distressed debt
Distressed debt is also a popular strategy at the trough of the credit cycle. In 2021, distressed strategies accounted for 22.3% of private debt AUM. While it reached a high of $24.2bn USD in Q4 2020 in North America, the strategy has yet to recover from the 2020 letdown. Distressed debt fundraising has fluctuated significantly since. Over the last year, fundraising slowed to a trickle, meeting an all-time low, closing zero funds in the first two quarters of 2022, and only $2.8bn in Q3 YTD. 

One of the key benefits of distressed debt is the potential for high returns. Distressed debt delivered a high net IRR from funds with vintages between 2015 and 2019 with 10.6, compared with direct lending which delivered 9.6 (Fig. 3). However, the standard deviation reveals a different story regarding risk management. Distressed debt had a standard deviation of 20.2, more than double that of direct lending, inferring that the strategy’s level of volatility may not justify the returns. So, under what circumstances might distressed debt be worth the risk?

Looking back
Distressed debt had a record-breaking year in 2020, reaching 31.49% median net IRR. However, this success failed to last as that percentage plummeted to 7.75% the following year. The pandemic saw unprecedented central bank support, which absorbed some distressed investment opportunities. It may be more advantageous to look at distressed debt’s performance in 2017. 

Distressed debt had its second-best year performance-wise in 2017, with a 13.7% median net IRR. At the time, the federal fund effective rate was on the rise, increasing from 0.65 at the beginning of Q1 to 1.3 by the end of Q4. US inflation was still below the 60-year average at 2.1, and GDP had declined from 8.2 to 2.4. In short, money was plentiful, inflation was relatively low, and the economy needed support. Enter distressed debt LPs.

Comparatively, GDP in Q1 2022 has been noticeably better, resting at 37.4, while the federal fund effective rate has climbed to 1.68 as of July 2022. The largest difference is inflation. Inflation rates are rising well above what LPs saw in 2017 which may warrant some pause. Though market conditions may be poised for distressed debt to thrive (Fig. 5), the strategy has yet to win back LPs’ confidence.

What comes next?
Higher inflation and rising financing costs can impede the creditworthiness of some borrowers who are struggling with increasing input costs. While LPs may gain some protection with floating-rate loans, combined with rising borrowing costs, the oil prices and geopolitical turmoil may continue to put pressure on the sector. The good news for lenders is that as banks take a step back and interest rates rise, private debt investors can invest at higher rates with better securities, offering compensation for the risk involved. While turbulent market conditions may have a negative impact on portfolios, the indicator of success will come down to if defaults come through.