Direct Lending: A Practitioner’s Guide

What Is Direct Lending?

Direct lending refers to non-bank private loans (typically senior secured) to middle-market companies, often sponsor-backed. Deals are bespoke, negotiated, and executed quickly versus syndicated markets.

Market Landscape

• Borrowers: sponsor-backed middle-market companies, roll-ups, and carve-outs.
• Lenders: private credit platforms (mega-managers to boutiques), BDCs, insurance affiliates.
• Use of proceeds: LBOs, add-ons, refis, dividend recaps, growth capital.
• Competition set: club deals among direct lenders; occasional bank/unitranche hybrids.

Expect cyclicality in volume, pricing, and structures as rates, defaults, and M&A activity shift.

Underwriting Checklist

• Business quality: moat, customer concentration, churn, pricing power, cyclicality.
• Financials: revenue mix, margins, cash conversion, capex intensity, FCF durability.
• Leverage & coverage: pro-forma net leverage, interest coverage, DSCR, liquidity runway.
• Management & sponsor: track record, alignment, reinvestment behavior, exit playbook.
• Industry risks: regulatory, technology disruption, input costs, FX/exposure.
• Collateral & structure: liens, guarantees, baskets, MFN protections, documentation quality.
• Downside case: sensitivities (−10/−20% EBITDA), covenant headroom, recovery analysis.

Leverage Norms & Pricing

• Leverage: middle-market unitranche often ~3.5x–5.5x net leverage (deal/sector dependent).
• Pricing: floating base (e.g., SOFR) + spread; OID and fees adjust all-in yield.
• Structure levers: cash vs PIK interest, amortization, delayed-draw tranches, accordion capacity.
• Return drivers: coupon, fees, prepayment/make-whole, equity kickers (selectively).

Ranges are indicative; actual terms vary by sponsor quality, competition, cyclicality, and asset risk.

Sponsor Dynamics

• Tiering matters: top-tier sponsors win better terms, speed, and flexibility.
• Alignment: rollover equity, management incentives, post-close behavior signal risk.
• Playbook: add-on M&A cadence, value-creation levers, exit strategy and timing.
• Information rights: reporting cadence, KPI dashboards, board/observer rights.

Documentation & Covenants

• Facility type: unitranche vs. split lien (first/second), revolver + term loan stacks.
• Financial covenants: leverage, interest coverage, FCCR; springing triggers on RCF.
• Negative covenants: debt baskets, restricted payments, investments, liens, asset sales.
• Builder baskets & RP capacity: calibrate to cash generation and sponsor plans.
• Protections: MFN, EBITDA definitions, add-back discipline, portability mechanics.

Monitoring, Certificates & Workouts

• Compliance certificates: quarterly testing, covenant headroom tracking, trend alerts.
• KPI monitoring: bookings, churn, AR turns, inventory weeks, pricing/mix.
• Amend-and-extend: early warning on liquidity crunch; negotiate give-gets.
• Workout planning: forbearance, milestone-based waivers, sponsor support, enforcement options.

Automation helps—pipeline, cert ingestion, variance analysis, and alerting should be systematized.

Common Pitfalls

• Over-reliance on aggressive EBITDA add-backs without cash proof.
• Ignoring working-capital drag and capex creep in FCF math.
• Underestimating customer concentration or supplier fragility.
• Weak definitions that hollow out covenants over time.
• Mismatched amendment strategy that burns sponsor goodwill.

Conclusion

Direct lending rewards disciplined underwriters who pair tight documentation with pragmatic sponsor partnerships. Nail the cash flow, document the protections, and monitor relentlessly—that’s the edge.