Direct lending's essential component within its operational structure
In the burgeoning world of direct lending, an often overlooked aspect is the management of leverage, a critical factor in the industry's growth. With loan-to-value ratios hovering around 60%, banks play a pivotal role in fuelling this growth [1].
Kanav Kalia, Managing Director at Oxane Partners, has highlighted the significance of the overlooked leverage management piece of direct lending's operating stack [2]. Managing leverage in direct lending is a substantial operational challenge, typically handled manually through spreadsheets and ad hoc workflows [1].
The complexity arises from the size and intricacy of the leverage involved. Direct lending firms, with assets under management (AUM) exceeding $1.5 trillion, often carry debt capital commitments that equate to a considerable portion of their funds [1]. This intensifies operational demands and risk exposure.
Moreover, the relationship between banks and direct lending firms is intricate. While banks have retreated from direct lending post-GFC, they still influence the industry by providing leverage and capital that drive private credit growth [1]. This interdependence creates risks that need to be carefully managed.
The technology and operating infrastructure supporting direct lending firms have primarily focused on deal sourcing, portfolio management, and AI-driven analytics. However, leverage management systems have been left behind, leading to inefficiencies in monitoring, controlling, and optimising leverage levels across funds and portfolios [1].
Recent market disruptions have exposed vulnerabilities, particularly in asset selection, when leverage is applied aggressively to borrowers with volatile cash flows or asset-heavy sectors sensitive to external shocks like tariffs or supply chain issues [3]. Managing leverage in this context is crucial to avoid disproportionate risks.
Balancing leverage and loss containment is another challenge. Operational reliability in servicing and managing loans requires not just efficient payment and monitoring systems but also sophisticated risk management around leverage to mitigate defaults and recoveries under stressed conditions [2].
In conclusion, the principal challenge is that leverage management in large direct lending firms is a significant operational and risk management task that has been underinvested in relative to other parts of the operating stack, even as these firms grow and leverage levels rise sharply [1][3][2]. The evolving complexity of fund structures, interconnectedness with banks, and sector-specific vulnerabilities underscore the strong demand for improved leverage management frameworks and technology solutions.
References:
[1] Kalia, K. (2021). The overlooked leverage management piece of direct lending’s operating stack. Oxane Partners.
[2] Direct Lending Investment Strategies: Navigating the New Normal. (2020). Preqin.
[3] Direct Lending: Navigating the Current Market Disruption. (2020). KPMG.
Direct lending firms, with their increasing assets under management and rising leverage levels, need to invest more in technology for efficient leverage management [1]. This is crucial to avoid disproportionate risks and manage operational challenges related to the complexity of leverage [1, 3, 2]. In the growing field of direct lending, a focus on technology for leverage management can help firms balance leverage and loss containment [1].
