A story about the drongo, the meerkat and debt markets

On the plains of Africa you’ll find a surprising cooperation between two typically adversarial animals—the drongo bird and the meerkat. What makes the relationship especially vexing is that they both covet the same food. But instead of being fierce adversaries, they maintain a symbiotic partnership. When predators to the meerkat are in the vicinity, the drongo bird will give out a warning cry, alerting the spirited mammals of the danger. The meerkats quickly scurry back to their burrows, and in their haste often drop a bit of food. The drongo swoops in and grabs the free meal, while the meerkat huddles in his hole avoiding the predator. A win-win.  

In a similar manner (albeit generally not on the plains of Africa), the relationship between broadly syndicated loans (BSL) and direct lending (DL) could be considered more symbiotic than adversarial as well. While in recent months the media has presented it as an either-or situation, with headlines like “Private credit’s golden era may face strain amid a resurgence in the BSL market,”¹ it is not necessarily so binary. In many instances borrowers can have their BSL cake and eat DL as well.

Increased deal flow—a win for credit investors

As banks increase their risk appetite, which they have in recent months given the strong macroeconomic backdrop, they will start putting more capital into the market in the form of BSL commitments. This bank action in some ways acts as a lubricant for the merger-and-acquisition (M&A) machine. The animal spirits come back and the pie grows. While DL may lose some share of the market to BSL as a result, in my experience there are enough deals with enough spread to keep both the drongo fat and the meerkat happy (Exhibit 1).

Any competition between BSL and DL, when it does occur, tends to happen in the upper middle market—companies with EBITDA² >US$100 million. Direct lenders in that portion of the market may lose some market share and see spreads compressed. However, the core middle market—companies with EBITDA between US$25 million-US$100 million—will still benefit from increased deal flow, as financial sponsors (the lifeblood of this segment) get more comfortable doing deals after a period of dormancy. It is still a win-win. Business media outlets like Bloomberg and others tend to underreport these middle-market transactions, because they lack the sensational value of a US$1 billion+ headline. These under the radar transactions are where alpha may be captured. For example, the core middle market still has a healthy, albeit diminished, illiquidity premium. In contrast, the upper middle market has seen its illiquidity premium over syndicated deals get squeezed significantly.

The bottom line is that it doesn’t have to be a binary selection between BSL or DL debt for allocators—there are opportunities in both. We see in Exhibit 2 that private credit deals continued to grow in number over the first quarter of 2024.     

The symbiotic relationship between BSL and DL is even more direct in some situations. More recently we are seeing deals that have both a BSL and DL structure. For example, in February of this year Ardonaugh Group Ltd.³ recapitalized its business with both DL and BSL components in the financing.

This practice isn’t abnormal. For many years, the typical LBO would have a first lien BSL component provided by collateralized loan obligations (CLOs), and a junior second-lien component provided by direct lending firms. Eventually lines got blurred and these structures became blended unitranche deals, where everyone was competing for the same pie. Today we're seeing a return of second-lien deals, such as the financing to support the leveraged buyout of Truist Financial Corp.’s insurance business.⁴ In my view, this practice is a better way of slicing the pie—the risk gets allocated appropriately. Those who want lower risk (BSL lenders) get the lower risk senior debt (first lien), and those seeking higher spread get the second-lien junior debt.  

Not always win-win: Covenant-lite growth may be warning sign

While both BSL and DL can coexist in the same market, there can be a downside to increased competition between the two debt structures. When markets get more competitive in the upper- middle-market segment, we often begin to see more risk-taking. Symptoms of froth, such as a lack of financial maintenance covenants (cov-lite) in documents, may become more frequent in DL structures. This should be the exception not the norm. This heightened risk can spread to the core middle market as well, which is not fully immune from these trends despite being more sheltered from competition. 

In conclusion, increased activity in the BSL space is not necessarily a bad thing for DL, and vice versa. They can coexist and even complement each other, providing a variety of financing options for different risk appetites. It is not an either/or condition, it is both/and. Even birds and cats get along sometimes.