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The Full Guide to Direct Lending: Industry, Companies & Careers
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Hardly anything in the modern finance industry is truly “new,” but direct lending might come closest.
Private debt markets have always existed, but direct lending – a specific subset of private debt – took off in a major way after the 2008 financial crisis.
As the large commercial banks stepped away from lending to middle-market and lower-middle-market companies, due to new regulations and economics, “alternative lenders” stepped in to fill the gap.
And in the process, they created a sub-industry that blends elements of private equity, mezzanine, and traditional bank lending.
Table Of Contents
Direct lending vs. private debt, direct lending vs. leveraged finance and debt capital markets, direct lending vs. mezzanine, direct lending recruiting & ideal candidates, direct lending fund interview questions and answers, direct lending case studies and modeling tests, direct lending jobs: deals, work, and hours, the top direct lending funds, direct lending salary + bonus levels, direct lending exit opportunities, is direct lending right for you, for further learning, what is direct lending.
Direct Lending Definition: Direct lending funds provide loans to middle-market companies that are originated and held by the lender rather than broadly syndicated; they are typically illiquid, senior secured loans with 5-7-year maturities and floating coupon rates, and returns expectations are in the high single digits to low double digits.
Just like private equity funds , direct lending (DL) funds raise capital from outside investors (Limited Partners) and then charge a management fee and incentive fee (carry), with a hurdle rate requirement to earn the incentive fee.
Unlike commercial banks, DL funds are unregulated, which means they can take higher risks and pursue deals that large commercial banks would reject or ignore.
Often, the financing required for middle-market M&A and buyout deals is in the “grey zone” for banks: it’s too large for the bank to fund directly but too small to be worth syndicating (i.e., splitting up the issuance and selling it to other investors).
So, instead of negotiating with several banks for a $150 million term loan, a company might find a direct lender that can fund the entire loan and complete the process quickly.
DL funds can also make deal processes more efficient by reducing the number of parties involved and the risk of leaks about the deal.
They’re often willing to lend up to higher multiples of EBITDA (e.g., 4.5x or 5.0x rather than 4.0x for a Term Loan)… in exchange for higher interest rates, of course.
I’ve used this image before, but this graph from Marquette Associates sums up various credit fields quite well:
These terms are often used interchangeably, but private debt is broader and includes direct loans, mezzanine , and forms of distressed debt .
“Private debt” means that the loan is funded directly by one investment firm rather than being syndicated and sold to many investors, and that that one investment firm plans to hold the loan until maturity.
Also, as the name implies, private debt is not publicly traded, so its market value is more difficult to determine.
But the terms, risk, and returns expectations for private debt vary widely, and distressed debt, at one end of the spectrum, is not comparable to the average direct loan.
The main differences here are:
- LevFin and DCM loans tend to be widely syndicated, i.e., the bank underwrites the loan, divides it, and sells it to a group of lenders called “the syndicate.”
- Direct lending funds are raised from Limited Partners such as pensions, endowments, and sovereign wealth funds, and they charge these LPs management and incentive fees. But if a bank holds a loan directly on its Balance Sheet, it’s funded by the bank’s deposits and debt, and the bank earns a small fee on the amount raised, with no incentive fee.
- Loan sizes tend to be smaller because direct lenders focus on middle-market companies.
Career-wise, direct lending is “better than DCM but not as good as LevFin.”
The work is more interesting than DCM since you get modeling and credit analysis exposure rather than constant market update slides.
But it’s still perceived as less modeling-intensive than LevFin or M&A or strong industry teams, and you’ll have fewer exit opportunities than in one of those.
The business models of direct lending funds and mezzanine funds are quite similar: raise money from outside investors, invest directly in issuances from companies, and charge a management fee and incentive fee.
But the risk and potential returns differ significantly:
- There is rarely equity participation with direct loans, but it’s common with mezzanine.
- Both types of loans may charge commitment fees, prepayment penalties, and other fees, but these fees tend to be higher for mezzanine.
- Capitalized or “Paid-in-Kind” (PIK) Interest is rare for direct loans but common for mezzanine.
- And direct loans are secured and have floating interest rates, while mezzanine issuances are unsecured and have fixed rates.
- Finally, mezzanine tends to fund the “last debt required” in deals, such as taking a company from 4x Debt / EBITDA to 5x Debt / EBITDA, while direct loans are used for funding up to that initial 4x.
Credit-related groups at the large banks work well if you want to break into direct lending. Think: Leveraged Finance , Restructuring , and M&A and industry teams with solid deal flow and debt-related deals.
Capital markets groups, such as ECM and DCM , are not great options because you don’t get much modeling exposure.
Areas like corporate banking , commercial banking, credit research, and credit rating agency work are in the “maybe” category: yes, you do credit analysis, but you don’t necessarily work on the types of deals that direct lenders execute.
If you’re working in one of those fields and you want to move into direct lending, you would boost your chances significantly by winning an IB role first.
It is possible to break in straight out of undergrad, especially if you’ve had credit-related internships at banks or other investment firms.
However, it’s not necessarily the best idea for the same reasons that private equity right out of undergrad may not be ideal : you limit your options and may not get meaningful work.
Recruiting tends to follow the off-cycle pattern at the smaller direct lenders and the on-cycle pattern at larger groups attached to the private equity mega-funds .
So, if you want to work at one of the huge funds doing direct lending, you’ll need to be prepared for headhunters and recruiting long in advance of the start date.
But if you’re fine with going to a smaller fund, you can take your time, network around, and join when they’re ready to hire someone.
The interview process is the standard one for any finance role: an HR phone screen or HireVue , a phone or video interview with an investment professional, and then a Superday with 3-4 people at the firm, possibly including a case study or modeling test as well.
Interview questions for DL roles can be summarized as: “Take the mezzanine fund and corporate banking articles and make sure you know the interview questions listed there.”
Since the questions are so similar, we’re not going to repeat everything here – but we will present a few of the most common fit and technical ones:
Walk me through your resume / tell me about yourself.
See our walk-through, guide, and examples for the “ Walk me through your resume ” question.
You can put more of a “lending” spin on it by saying that the capital structure element of deals interests you most, and you want to work on that specific aspect.
What do direct lenders do?
They provide loans to mid-sized and smaller companies that are directly originated with no or minimal syndication. The loans are senior secured with 5-7-year maturities and floating interest rates, and direct lenders typically hold them until maturity.
The direct lending market exists because large banks stepped away after the 2008 financial crisis, partially due to new regulations and partially due to economics and industry consolidation.
Why direct lending rather than private equity or mezzanine?
You want to work on and close deals rather than looking at dozens or hundreds of deals and rejecting most of them right away, as in PE, and you like assessing companies’ credit risk.
You prefer direct lending over mezzanine because mezzanine is more of a split debt/equity focus, and you want to focus on the credit side.
What are some of the key maintenance covenants that you would analyze in a credit deal?
Maintenance covenants relate to financial metrics that the company must maintain after it raises debt.
The most common ones include the Leverage Ratio, or Debt / EBITDA, and the Interest Coverage Ratio, or EBITDA / Interest (and variations like Net Debt rather than Debt, or EBITDA – CapEx rather than EBITDA).
For example, secured loans often require companies to maintain Debt / EBITDA below a certain number, such as 5x, and EBITDA / Interest above a certain number, such as 2x.
How do you calculate the Fixed Charge Coverage Ratio (FCCR) and the Debt Service Coverage Ratio (DSCR), and what do they mean?
Both metrics may be defined in slightly different ways, but the FCCR is usually something like (EBIT + Non-Interest Fixed Charges) / (Non-Interest Fixed Charges + Interest Expense + Mandatory Principal Repayments).
The FCCR tells you how well the company’s business earnings can pay for its “fixed” expenses, such as rent/leases, utilities, and debt interest and principal repayments. Higher coverage is better.
The DSCR can also be defined differently, but we often use (Free Cash Flow + Interest Expense) / (Interest Expense + Mandatory Principal Repayments).
Some people also use EBITDA – CapEx, EBITDA – CapEx – Cash Taxes, or other variations in the numerator.
This one measures a company’s ability to pay for its debt with its business cash flow, and it does not consider other fixed expenses such as rent. Higher numbers are better.
What qualities would you look for in a company that’s seeking funding from us?
This one is covered in the corporate banking article; the criteria are quite similar.
You want companies with predictable, locked-in, recurring revenue, ones that can survive a downturn or industry decline, ones with low existing debt levels, and ones with low CapEx requirements and fixed expenses.
It also helps to be an industry leader in a growing market.
How can you quickly approximate the Yield to Maturity (YTM) on a bond?
We have a tutorial on this one, so please refer to it:
How to Approximate the Yield to Maturity (YTM) on Bonds
Suppose that we issue a $200 million loan to a middle-market IT services company to fund a leveraged buyout. It has a 7-year maturity, a floating interest rate of Benchmark Rate + 600 bps, an origination fee of 1%, and a prepayment penalty of 2%. What is the approximate IRR if the company repays this loan at the end of Year 5, and the Benchmark Rate rises from 1% in Year 1 to 3% in Year 5? Assume no principal repayments.
The interest rate here starts at 7% and rises to 9% by the end, so the “average” rate is 8%.
The origination fee is 1%, and the prepayment fee is 2%, so the lender earns 3% extra over 5 years; 3% / 5 = slightly more than 0.5% since 3% / 6 is exactly 0.5%.
You could say, “Between 8% and 9%, but slightly closer to 9%” for the answer.
In Excel, the IRR is 8.51%.
If you get a case study or modeling test, it will likely take this form:
“Please read this CIM or a few pages of information about this company, build a 3-statement or cash flow model, and make an investment recommendation about the potential Term Loan A/B or other loan issuance.”
If this is an on-site case study for 90 minutes up to 3-4 hours, skip the fancy models and create Income Statement projections, a bridge to Free Cash Flow, and a simple Debt Schedule .
You do not need to calculate the equity IRR, you don’t need purchase price allocation , and you don’t need the full financial statements to complete these case studies.
Building the correct operational cases, focusing on the pessimistic scenarios, and make sure you include the right credit metrics, such as the DSCR and Leverage and Coverage Ratios.
Sensitivities help but are not necessarily essential if you have reasonable scenarios.
Credit case studies are all about assessing the downside risk and rejecting deals where there’s even a chance of losing money if the company performs below expectations.
For a good example of what to expect, see our Debt vs. Equity case study on YouTube:
Debt vs. Equity Analysis: How to Advise Companies on Financing
Your write-up can follow the standard structure: yes or no decision in the beginning, the credit stats and potential losses in different cases, and the qualitative factors that support your decision (e.g., resistance to recessions, recurring revenue percentage, customer and revenue diversification, margin strength, fixed costs, and industry position).
If this is more of a take-home case study where you have several days or a week to finish, you still should not create a super-complex model.
Use cash flow projections and build the full financial statements only if they’re required.
Instead, use the extra time to do additional research so you can back up your numbers more effectively when you present your recommendation.
The direct lending job itself, at least as an Associate, is similar to what you do in other credit and buy-side roles: origination, due diligence, process work, and financial modeling.
However, the “due diligence” part is often compressed because you look at so many deals and need to decide quickly.
It’s not like private equity, where your team could potentially take months to dig through a single company’s financial data and do on-site diligence.
The steps in a typical deal process might look like this:
1) Receive Non-Disclosure Agreement (NDA) from a Banker or Financial Sponsor – You then mark it up and agree on the changes, and both sides execute it so that you can receive information about the company and deal.
2) Receive and Analyze the Confidential Information Memorandum (CIM) – The bank or financial sponsor sends you the CIM, you build a simple cash flow model to assess the credit risk, and your team makes an initial decision on whether to go forward.
3) Submit an Indication of Interest (IOI) or Letter of Intent (LOI) – You outline your proposed investment terms, including the maturity of the loan, the fees, the interest rate, and so on.
4) Advance to the Next Round – If you’re selected, you complete more due diligence over the next few weeks, including a more detailed model, a review of the data room, and more detailed analysis of customers, revenue sources, and profitability by product/region/customer.
5) Write and Present Your Findings – You’ll then write a more detailed credit memo and present your findings to the investment committee.
6) If Approved, Close the Deal and Monitor the Company – If the committee likes it, they’ll approve the deal and transfer the funds, and you’ll start monitoring the company and reviewing its performance each quarter.
If you’re at an independent direct lending or private debt fund, the average weekly hours might be in the 50-60 range, with occasional spikes when deals close.
The hours are shorter than those in traditional private equity because direct lenders tend to do less due diligence, they have less concentrated portfolios, and they rely on sponsor relationships rather than cold outreach to win deals.
However, note that if you’re in direct lending at a PE mega-fund, your hours and stress levels might be nearly the same as they are in traditional PE.
There are two main groups: managers linked to much larger private equity firms/hedge funds/investment banks, and “independent” managers with a credit focus.
In the first category are firms like Ares, Goldman Sachs Merchant Banking , Apollo, Bain Capital, KKR, Blackstone (GSO), Cerberus, Fortress, and Centerbridge.
In the second category are firms like Oaktree, Golub, Intermediate Capital Group, HPS Partners, PennantPark, Crescent Capital, Owl Rock, CarVal Investors, Hayfin, First Eagle, Maranon, and dozens of others.
Many of these firms also make mezzanine and other private debt investments, and some even make growth equity and equity co-investments as well.
While direct lending funds and private equity funds have similar business models, there are a few important differences:
- Fees Are Often Lower – For example, the management fee might be closer to 1% rather than 2%, and the incentive fee might be 10% or 15% rather than 20%.
- Fees Might Be Charged Based on Deployed Capital Rather Than Raised Capital – So, if your fund raised $1 billion but has only invested $200 million, the 1-2% management fee might be charged on the $200 million rather than the $1 billion.
As a result of these differences, average compensation tends to be lower.
The rule of thumb is “Take IB/PE base salaries and assume lower bonuses.”
So, the approximate total compensation ranges are:
- Analyst: $90K to $140K
- Associate: $125K to $250K
- Senior Associate / Assistant Vice President: $200K to $350K
- Vice President: $300K to $500K
- Principal / Senior Vice President: $450K to $700K
- Managing Director: $400K to just over $1 million
The bonus starts at a relatively low percentage of base salary (10 – 50%), but rises to 100% by the mid-levels and potentially over 100% for MDs.
These are wide compensation ranges because of the differences between different fund types.
For example, an Associate who just finished an IB Analyst program and joined a larger, well-known direct lender might earn total compensation of $200K to $250K.
But at a smaller firm that’s unattached to a large bank or PE firm, total compensation might be closer to $150K.
The bottom line: you still earn a lot in direct lending, but it is a discount to private equity salaries and bonuses , and the “ceiling” tends to be lower because of the lower fees.
Note that we’re not including carried interest in these figures – if we did, there would be an even bigger difference between DL and PE pay at the top levels.
After the “What is direct lending?” question, the second-most-common one is “What do people do after direct lending? What are the exit opportunities? Show me the exit opps!!”
Unfortunately, the answer is quite boring: “Stay in the space and work their way up at the same fund or move to a different fund.”
One of the major disadvantages of direct lending is that it tends to be difficult to move into other industries, even ones related to credit, such as distressed private equity , standard private equity , or credit hedge funds.
The issue is that you work mostly with secured debt, not the high-yield or distressed issuances that these other firms buy and sell.
Also, while PE and DL share some aspects, the “investing philosophy” is quite different since one is a pure equity role, and the other is a pure debt role.
I’m sure that some people have moved from DL to PE, but it’s more difficult than you would think; the reverse move is easier.
Mezzanine funds might be one potential exit opportunity, especially if you worked at a fund that did more than secured loans.
And if you go to a mezzanine fund, you open up exit opportunities at some of the other firm types mentioned above.
These limited exit opportunities also explain why it may not be a great idea to start in direct lending out of undergrad: Leveraged Finance would pay you more and give you more options.
You would be a good fit for direct lending if you want to work on many different deals but not go into each one in extreme depth, and you want to do only credit analysis without considering the equity side.
You would also be a good fit if you want a slightly better lifestyle, still-high-but-lower-than-PE compensation, and you want to stay in credit for the long term.
You would not be a good fit if you want to analyze the equity side of deals, work directly with portfolio companies’ operations, or make the most amount of money possible.
Also, if you’re not sure you want to be in credit for the long term, stay away – because most people in direct lending do end up staying for the long term.
Personal Opinion: While direct lending roles are fine, you could get many of the same benefits (shorter hours in exchange for slightly lower pay, more deals, etc.) by joining a mezzanine fund.
You would also gain access to more exit opportunities, so you could move around more easily if you decide it’s not for you.
So, I’m not sure why you’d choose direct lending over mezzanine if you interview around and win offers in both fields.
Here are some links if you want to learn more about the field:
- Direct Lending Overview by Hewitt ennisknupp
- Supercharged Fixed Income – Direct Lending by Marquette Associates
- The Rise of Private Markets and Non-Bank Lending by Ares
About the Author
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street . In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.
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12 thoughts on “ The Full Guide to Direct Lending: Industry, Companies & Careers ”
I work in sponsor finance in commercial banking; we make first lien loans for private equity transactions. Do you think this is helpful experience for direct lending roles?
Potentially, yes.
Useful article! Do you know what the responsibilities, comp, and exit opps look like for a portfolio management analyst or associate at a direct lender?
Different lending shops define PM differently and some have a separate team for it whereas others have associates handling PM tasks in addition to sourcing / underwriting / DDing new investments. Thanks.
Sorry, we don’t have information on that one. Most compensation surveys do not have much specific information on direct lending or differences in the different DL groups.
Hi Brian, thanks for the article. I am headed into a corporate banking role this summer in a bank with CIB umbrella structure. I sometimes get confused when you refer to lack of deal experience when it comes to corporate versus investment banking roles: if I am doing credit analysis/due diligence, modeling, and helping to execute on project financing, term loans, etc. where my firm has “skin in the game”, why are those less of a transaction than syndicating loans on the LevFin or DCM side?
CB deals are somewhat different because you don’t necessarily do as much modeling work, and the hours and intensity are lower because the debt issuances in CB are usually not related to deals. But it does vary by bank, and at some firms, there’s barely any difference between CB and IB, or they’re even grouped together.
I’m currently a student looking at a prospective summer internship.
I was wondering what are your thoughts regarding Credit Portfolio Advisory (specifically at Alantra, Dublin). They have a team that apparently advises on credit transactions.
My eventual goal was to join a credit fund like GSO or Guggenheim but this idea of ‘advising’ on credit transactions somewhat confuses me (as I thought all decisions were analysed and made by the deal parties without ‘middlemen advisors’).
Job description looks pretty similar to a credit fund analyst (but considering those are written by HR… I’d rather not trust them lol).
Any opinions on this credit advisory service, Alantra, exit ops etc. is much appreciated if you have any insight^
Thank you!!!
Sorry, I don’t know enough about that specific group to say much. From the description, it seems like the exit opportunities would be similar to the ones discussed here. Not sure if the top credit funds would be realistic, but other credit funds, direct lenders, maybe mezzanine, etc. would be possible.
Hey Brian. Have you seen individuals move from commercial banking (C&I Lending) straight to Direct Lending? What do you think are the main areas or skills a commercial banking lender should focus on in order to transition his or her career to direct lending?
Not offhand, no, because the skill sets are somewhat different. You need to show more evidence of financial modeling and investing skills to move into direct lending. I’m sure some people have moved in from commercial banking, but it’s not as easy as you might think.
Great article. Do you know of any shops that hire recent grads with little to know experience?
Thanks. Some of the mega-funds that also have credit arms do hire undergrads (Apollo, Bain Capital Credit, KKR Credit, Ares, Oaktree, etc.). But you usually need some type of experience, such as previous internships, to have a good shot at those.
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Direct Lending: Benefits, Risks and Opportunities
Direct lending may generate attractive returns with less downside risk and mark-to-market volatility than more liquid credit strategies like broadly syndicated loans.
Debt financing needs could grow in the coming years because middle-market companies face a significant maturity wall and private equity sponsors may drive deal activity with the sizable store of capital they have on hand.
Superior risk control may be achievable because direct lenders have better access to management than investors in more liquid strategies and the ability to design bespoke creditor-friendly structures.
Tax-efficient investment solutions are available for limited partners from many geographies.
Outperformance may require superior deal sourcing capabilities and underwriting skill as well as extensive experience crafting creative solutions in complex situations.
What Is Direct Lending?
Direct lenders are non-bank creditors that make loans to businesses without using an intermediary, such as an investment bank. Direct lending, a subset of private debt, most commonly refers to first lien loans made to middle-market companies (i.e., those that report between $50 million and $1 billion in annual revenue); however, Oaktree broadens the definition beyond first lien loans to encompass many additional forms of middle-market lending, including second lien debt, mezzanine debt and unitranche debt (i.e., hybrid loans combining junior and senior debt). There are over 200,000 middle-market companies in the United States alone: a vast market that accounts for one-third of U.S. private-sector GDP and employment – a sum that would make it the world’s fifth-largest economy. 1 Middle-market companies also play a significant role in Europe, representing around a third of private-sector employment in the four largest economies. 2 Loans made to middle-market businesses are normally used to finance leveraged buyouts (LBOs), mergers and acquisitions (M&A), growth investments, and recapitalizations.
Direct lending investments typically have:
Floating-Rate Coupons: Interest rates are normally quoted as a spread above a reference rate, such as LIBOR 3 or the Secured Overnight Financing Rate (SOFR).
Short Terms to Maturity: The average term to maturity on these loans is between five and six years compared to over seven years for high yield bonds, and the loans’ average lifespan is between three and four years.
Strong Covenants: Loan contracts usually include negative and affirmative covenants that limit the borrower’s ability to reduce the value of the loan. These include maintenance-based covenants, which are tested at regular intervals throughout the life of the loan. These lender protections require companies to meet certain financial conditions, such as keeping their ratio of debt to EBITDA below a specific level.
Less Liquidity: Lenders can’t move in and out of these investments as easily as investors can normally buy and sell broadly syndicated loans (BSLs) and high yield bonds; however, lenders are typically compensated for this risk with the possibility of additional return – the so-called illiquidity premium.
Low Correlation with Public Markets: Because of the bespoke nature of direct lending deals, returns are normally not highly correlated with those of public debt and equity markets.
Direct lending, like private debt in general, has grown significantly since the Global Financial Crisis of 2007-2008. In the U.S., direct lending assets under management jumped by over 800% in the decade following the GFC. 4 By 2020, the total U.S. direct lending market had grown to around $800 billion, according to a Refinitiv estimate. 5 This growth has been due in part to the declining presence of banks in middle-market lending – a trend that began in the 1990s (see Figure 1). At that time, regional U.S. banks that serviced middle-market companies began consolidating; the resulting larger banks focused less on lending to small- and medium-sized companies and more on fee-based business lines and financings for larger firms.
The GFC accelerated this consolidation trend, and the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, introduced enhanced rules and regulatory requirements that intensified underwriting standards and mandated that banks hold additional capital against assets. These changes further decreased banks’ ability and willingness to issue and hold loans to middle-market companies, especially businesses with riskier credit profiles. The impact of these shifts is underscored in leveraged loan primary market statistics: U.S. banks were responsible for over 70% in 1994, but only around 10% by 2020 (see Figure 1).
Figure 1: Primary Market Corporate Loan Participation
As of December 31, 2020 Source: S&P LCD
Figure 2: European Direct Lending Assets Under Management
As of Septemer 30, 2020 Source: Preqin
In Europe, banks play a much larger role in funding corporations than banks do in the U.S., where businesses rely more on the capital markets. However, European banks’ control over middle-market financing was declining for much of the last decade. For example, European banks’ outstanding corporate loan volumes were relatively stagnant in the years leading up to 2020. During the same period, European direct lending assets under management skyrocketed from almost nothing in 2009 to over $150 billion in 2020 (see Figure 2).
Opportunities
Oaktree participates in four types of direct lending opportunities across many geographies:
Situational Lending: Loans to companies with nontraditional revenue or earnings histories, such as those that report high levels of revenue but no earnings. Traditional lenders like banks may be unable to properly value these companies’ assets.
Example: A life sciences company with revenue-generating drugs and substantial hard assets seeking to commercialize a promising new product
Stressed Sector / Rescue Lending: Loans to companies in sectors experiencing stress and reduced access to the capital markets.
Example: A business in an industry negatively affected by the Covid-19 pandemic, such as entertainment or travel
Secondary Private Loans and Loan Portfolios: Direct loans or portfolios of loans sold by investors or leverage providers. Sellers might be forced to offload loans in response to near-term liquidity needs, leverage pressures, regulatory capital requirements, or performance concerns.
Example: Loans sold by banks looking to reduce geographic or sector concentration
Sponsor Financings: Loans related to LBOs, where the lender works with sponsors who have subject-matter expertise in more complex industries.
Example: Loans to fund LBOs in partnership with a software-focused private equity firm
What Are the Benefits of Direct Lending?
Direct lending portfolios, if structured properly, have the potential to generate returns similar to or higher than those of other credit investments such as BSLs, but with less risk. Additionally, an allocation to direct lending enables investors to gain exposure to private-equity-sponsored deals without assuming the same level of risk as equity investors. The advantages versus many other types of debt investments include:
Greater Protection From Rising Interest Rates: Loans have shorter duration (i.e., lessor sensitivity to interest rate changes) than fixed-rate debt. Unlike most debt instruments, many loans don’t decline in value as interest rates increase because they have floating-rate coupons that increase in line with the underlying reference rate. Duration is also shortened because loans usually feature all-cash coupons, while some high yield bonds include payment-in-kind, or PIK, coupons, which are paid with the principal at maturity. Middle-market loans may also include call protection, which reduces prepayment risk by restricting borrowers from retiring loans within a few years of issuance, and prepayment penalties. Additionally, floating-rate loans normally have contracted floors on the reference rate, offering some protection when rates decline.
Higher Seniority and Security: Loans are first in line in the capital structure to be paid out in the event of a default. Senior loans have the initial claim on assets, such as cash, accounts receivable and equipment; junior loans have subordinated claims, but are still senior to bonds.
Greater Lender Protections: These loans typically offer strong downside protection because they are collateralized and high in the capital structure. Additionally, the loan contracts normally include both incurrence covenants, which are applied when the company seeks to take an action like adding additional debt, and maintenance covenants, which restrict certain activities and require companies to maintain specific leverage and interest-coverage metrics that are measured at least quarterly. Meanwhile, BSLs are increasingly classified as covenant-lite because they rarely include maintenance covenants.
Lower Potential Losses in a Default: The average recovery rate for U.S. middle-market senior loans between 1989 and 2018 was 75% – far higher than the 56% for senior secured bonds (see Figure 3). Additionally, around 59% of the average U.S. middle-market LBO purchase price was financed by equity in 2020, meaning that the company would have to lose more than 59% of its value before the loan would be impaired (see Figure 4). That’s far more than the 44% equity contribution reported for large-company LBOs.
Figure 3: Recovery Rates by Asset Class (1989-2018)
As of December 31, 2018 Source: S&P CreditPro Note: Recovery rates are calculated as the value received in settlement, discounted at the effective interest rate on the instrument, as a percentage of the principal default amount.
Figure 4: Total Equity Contribution For LBOs
As of December 31, 2020 Source: Refinitiv LPC
More Upside Potential: First lien middle-market loans have offered more yield spread per unit of leverage since late 2016 compared to first lien large-corporation LBO loans (see Figure 5). Middle-market loans also feature warrants and other sweeteners more frequently than other credit instruments, providing debt investors with the ability to enjoy equity upside potential along with downside protection.
Figure 5: Compensation Potential in Middle-Market and Large-Corporation Loans
More Control: While direct lending normally requires greater due diligence than traditional debt investment strategies – more akin to the private equity norm – this relationship-based lending model gives the lender more access to the company before and after deal inception and greater control over terms and structure – which can be especially advantageous in adverse scenarios.
Higher Illiquidity Premium: Direct lenders can often secure higher origination fees and coupon rates compared to investors in BSLs, which are more liquid. Middle-market companies with fewer borrowing options are often focused on the certainty of capital rather than just the cost of capital.
Lower Volatility: The marked-to-market valuations of direct lenders’ investments normally aren’t as volatile as those of high yield bonds or more liquid loans, and price volatility is commonly used to represent risk in risk-adjusted return calculations.
Greater Diversification: Private loan performance is often not well correlated with that of other types of assets or with the business cycle in general. This is especially true in industries with highly specialized products; for example, in life sciences, individual companies are often focused on different diseases, reducing intra-sector-concentration risk. The large size of the universe also helps lenders create more diversified portfolios, as they can access opportunities unavailable to investors limited to the public markets.
What Are the Biggest Risks in Direct Lending?
The relationship-based nature of direct lending and the bespoke nature of the loans involved mean one’s ability to properly source, underwrite, structure, and monitor an investment is even more important here than in traditional credit strategies. This is a demanding workload, which could overwhelm inexperienced investors. Problems may arise at any stage in the lending process:
Failure to Establish a Robust Sourcing Pipeline: Increased competition for direct lending deals means established firms with large origination platforms and strong deal sourcing pipelines will have a significant advantage over newer, smaller funds.
Failure to Manage Fund-Level Leverage: Direct lending funds may use leverage offered by commercial banks to amplify the returns on their investments. However, the term of the fund-level leverage is often shorter than that of the underlying assets, which creates leverage refinancing risk. Additionally, leverage providers may demand quick repayment when the assessed value of the direct lenders’ portfolio companies declines – even if this decrease is minimal – which can magnify liquidity problems in a downcycle.
Failure to Complete Proper Due Diligence: Direct lending requires the type of extensive research normally associated with private equity transactions – far more than is often necessary or feasible with BSLs. Not only must lenders have the proper staff and resources, but investing in certain industries, like life sciences or software, also requires lenders to possess sector-specific expertise.
Failure to Properly Structure the Investment: Firms without structuring expertise or with narrow investment mandates may lack the creativity and flexibility needed to adapt to borrowers’ needs and thus be unable to seize attractive opportunities or design financing structures that could maximize risk-adjusted return potential. Firms may also lack the resources to properly address the legal, tax and regulatory concerns that arise when setting up bespoke structures.
Failure to Sustain Active Management: Successful direct lending requires continuous monitoring of investments. This demands discipline, resources and experience so that problems can be identified and addressed early.
Failure to Properly Navigate a Restructuring: Firms with limited experience in distressed situations and challenging economic environments may lack the skills needed to identify early warning signs of distress, return a company to solid financial footing, or maximize the recovery value of an investment.
The past decade’s ultra-low interest rate environment increased investor appetite for the attractive risk-adjusted returns that can potentially be secured through direct lending. This competition has enabled companies with weaker balance sheets to borrow and to offer fewer investor protections when doing so. For example, leverage multiples of five to six times EBITDA have become more commonplace even for firms with EBITDA under $20 million. Lenders have also been agreeing to more generous earnings add-backs that inflate EBITDA, making leverage levels appear artificially low. Demand for private investments is also reducing illiquidity premiums and enabling some borrowers to dilute lenders’ call protection. This competition will likely only intensify in the near term if fear of rising interest rates increases demand for floating-rate products.
How Does Oaktree Seek to Address These Risks?
Oaktree believes many of the aforementioned risks can create opportunities for experienced contrarian investors who prioritize downside protection and patience over immediate capital deployment – those who never seek to do a deal “at any price.” With an 18-year track record in middle-market direct lending – representing over 300 transactions and $11 billion in financings in many geographies – Oaktree believes it has developed the skill set needed to control risk at every stage in the lending process.
Sourcing: Oaktree maintains relationships with over 200 sponsors as well as many advisors, commercial banks and capital markets teams, which we believe provides us with a comprehensive view of the investment universe. Our dedicated sourcing and origination platform has helped us maintain and expand these relationships; they are enhanced by our strong reputation for keeping our word and honoring our commitments. Also, when we work with sponsors, we prioritize invitation-only opportunities from private equity firms with which we already have relationships because: (1) we don’t face as much competition for these deals; (2) our familiarity with the sponsors normally speeds up the deal process and increases the probability of closure; and (3) our longstanding relationships help us gauge how sponsors will act during the investment’s life cycle, including in a possible restructuring.
Selectivity: Oaktree seeks to be highly selective when choosing partners and investments. Historically, actual investments have represented around 3% of the total financings our direct lending funds have considered, as potential opportunities must survive a rigorous screening process involving extensive due diligence. For example, Oaktree often engages its own third-party experts prior to making an investment in addition to fully reviewing the sponsor’s diligence analyses and all buy-side and sell-side commissioned third-party reports. This independent and comprehensive due diligence is highly valued by private equity sponsors, who repeatedly partner with Oaktree to benefit from the firm’s insights and vast resources. This advantage better enables us to demand attractive terms that can bolster downside protection.
Valuation: Oaktree employs a loan-to-value approach using what it considers to be conservative assumptions unlike many lenders who use a simplistic multiples-based approach or more aggressive assumptions. We believe beginning with an appropriate company valuation is key to securing downside protection.
Structuring: Oaktree’s extensive experience with complex financings enables us to more easily identify structural risks and develop creative solutions. This means deals are designed so that Oaktree can limit potential losses in negative scenarios, mitigate tax concerns, and navigate local regulatory regimes.
Monitoring: Oaktree continuously monitors portfolio companies and has extensive access to companies’ management teams and sponsors so that we can manage overall risk and begin risk-mitigating discussions with companies long before covenants are breached.
How Can an Investor Address Tax Concerns?
U.S. tax law considers loan origination to be engagement in a business or trade, so investors both inside and outside the U.S. may therefore have concerns about increased taxes stemming from direct lending. However, there are numerous tax-efficient strategies available to address these concerns.
Ex-U.S. Investors
For U.S. income tax purposes, all income a foreign person realizes from a trade or business in the U.S. is considered effectively connected income (ECI) and is therefore subject to taxation. As stated above, this often includes income related to direct lending.
For large investors domiciled in countries with favorable tax treaties, such as Canada, Japan, the United Kingdom and many EU countries, this tax concern may be addressed with a bespoke fund-of-one solution. The investor would still be subject to state income taxes and be required to file U.S. tax returns.
Ex-U.S. clients may invest through a levered blocker corporation, which blocks ECI and eliminates the need for U.S. tax filings. However, regular corporate tax and withholding tax may still be imposed on dividends and interest income. The effective tax rate is generally expected to be between 10–35%, depending on whether the investor holds less than 10% of the blocker, the amount of debt in the structure, the cash distribution profile, and the tax treaty of the country in which the investor is domiciled. If a sovereign wealth fund owns less than half of the blocker, then its interest income and dividends won’t be subject to U.S. taxation.
Some investors may gain exposure to direct lending without being subject to ECI tax by investing through a Business Development Company (BDC). However, this tax-efficient structure may be inappropriate in some situations. Please see the BDC overview for more details.
Ex-U.S. investors are generally not subject to the ECI tax if the loans in the direct lending fund are to non-U.S. companies and structured properly.
U.S. Investors
Tax-exempt U.S. investors – including corporate pension plans, foundations and endowments – may be subject to tax on unrelated business taxable income (UBTI) related to leverage used by a direct lending fund.
Tax-exempt investors with UBTI sensitivity can normally mitigate this tax concern by gaining exposure to direct lending through a U.S. blocker corporation vehicle, which is similar to the levered blocker described above for non-U.S. investors.
U.S. tax-exempt investors can also generally avoid being subject to UBTI by investing through a BDC. Please see the BDC overview for more details.
So-called super tax-exempt investors like public pension plans are normally not subject to U.S. taxation, including income related to direct lending.
All other taxable U.S. investors will be taxed on income realized through direct lending, but these taxes may be reduced by investing through a BDC. Again, please see the BDC overview for more details.
In addition to U.S. taxes, investors may also be concerned about local withholding taxes on interest from the borrowing company’s jurisdiction. These concerns can often be addressed with specific investment structures: for example, investing through a Luxembourg corporation for loans to European companies. Oaktree has well-established regional investment platforms that can help clients mitigate the impact of taxes on returns.
What Might the Post-Pandemic-Era Opportunity Set Look Like?
Middle-market companies in many regions will likely require significant refinancing capital moving forward. First, U.S. companies face an impending maturity wall: over $550 billion in middle-market debt is scheduled to mature through 2027 (see Figure 6). Also, European banks may have limited lending capacity, so European firms that have faced extended Covid-19 lockdowns may struggle to refinance upcoming maturities. Additionally, some U.S. firms’ BDCs have struggled during the pandemic: the non-accrual rate (i.e., the percentage of loans with payments over 90 days late) hit 5.1% in the third quarter of 2020, topping the record 4.5% middle-market loan default rate experienced in 2009. This stress could increase the need for refinancings and generate forced asset sales, creating attractive buying opportunities for patient investors.
Figure 6: Middle-Market Loan Amounts Maturing Through 2027
We believe that the best opportunities may be found in either beaten-down industries, such as travel and leisure, or industries requiring more subject-matter expertise, like healthcare or information technology:
“Unloved” Sectors: Many creditors eschew all companies in a troubled sector, potentially increasing the interest rates willing lenders can secure. Locating bargains requires portfolio managers to have both skill and discipline, as they must conduct rigorous issuer-by-issuer analysis to identify strong companies whose fundamentals belie their stressed-sector discount. Additionally, significant structuring expertise is needed to ensure investments offer sufficient downside protection.
Complex Sectors: Successful investment in sectors with highly technical products and assets, such as life sciences and software, requires specialized expertise. Many traditional lenders often won’t lend to these types of companies because the businesses’ lack of stable earnings makes simple multiples-based valuation techniques unworkable.
The demand for capital from direct lenders is already rebounding from the Covid-19-induced pullback in the second and third quarters of 2020. M&A and LBO activity declined during this period because financial market participants were unwilling to transact given the uncertainty created by the pandemic. However, by the fourth quarter, worst-case scenarios in many sectors had failed to materialize, and deal flow not only bounced back, it reached record levels, and activity has remained robust thus far in 2021. Moving forward, demand for debt financing could increase because private equity funds focused on middle-market companies have over $80 billion in dry powder available to drive LBO activity. 6
This historical moment is characterized by a lack of clarity, so it’s more important than ever that direct lenders possess an uncommon skillset: capital discipline, sector-specific expertise, strong sourcing relationships, knowledge of tax-efficient strategies, and structuring experience. The pandemic has accelerated some trends – such as the shift to e-commerce and interest in advanced healthcare solutions – but it has also introduced new anxieties, like those over rising inflation. Lending into such uncertainty demands consideration of downside protection as well as upside potential. As our co-founder Howard Marks has long said, “we can’t predict, but we can prepare.”
Business Development Companies (BDCs)
What are BDCs?
Business Development Companies are closed-end investment vehicles that were created by the U.S. Congress in the 1980s to invest in and provide managerial support to small- and medium-sized enterprises. They are regulated like an investment company but have filing demands similar to those of an operating company.
BDCs are characterized by a unique set of requirements:
Seventy percent of the BDC’s total assets must be invested in “eligible portfolio companies” (i.e., U.S. private businesses or U.S. public companies with a market capitalization under $250 million).
The BDC must offer significant managerial assistance to its eligible portfolio companies.
No single investment may account for more than one-quarter of total assets, and over half of all investments must each represent under 5% of total assets.
The BDC’s debt-to-equity ratio may not exceed two to one.
Annual shareholder meetings must be held to elect a Board of Directors, depending on the jurisdiction and corporate structure.
The BDC must file quarterly financial reports (10-Qs) and annual financial reports (10-Ks), including valuation disclosures of all investments.
BDCs can either be publicly listed on exchanges and offer daily liquidity or be structured as unlisted vehicles with defined investment and wind-down periods. Investors own shares in a BDC.
What are the tax benefits of BDCs?
Most BDCs elect to be formed as a Regulated Investment Company (RIC), an entity that isn’t subject to federal corporate income tax provided all of its taxable income is distributed to investors and the BDC meets certain source-of-income and asset-diversification requirements. A BDC will also block ECI and UBTI from flowing through to the investors. Most of the dividends paid to non-U.S. investors aren’t subject to U.S. withholding taxes because the BDC’s income is primarily derived from interest income. Additionally, BDC tax reporting is relatively simple and similar to the process used when investing in mutual funds (i.e., a 1099 form is submitted). Investors aren’t required to file federal or state returns around a liquidity event.
What are the other benefits of BDCs?
Federal regulations mandate:
dividend distributions,
greater transparency through quarterly reporting, and
limitations on the use of leverage.
What are some of the drawbacks of BDCs?
Federal regulations restrict BDCs’ potential investment opportunities.
Operational expenses are much higher than those of a non-BDC-structured fund because they include the cost of a Board of Directors, public filing fees, and other regulatory/compliance costs.
BDCs may not be the best option for investors from some European countries.
What differentiates Oaktree’s approach to BDCs?
Oaktree’s extensive firm-wide credit platform gives us access to higher quality deal flow compared to the typical BDC, meaning we can be more selective and potentially secure better terms – the foundation of risk control in direct lending. Oaktree also believes it can keep its expenses low because we have a well-established, scalable operations platform.
1 The National Center for the Middle Market 2 Invest Europe 3 LIBOR was formerly an acronym for the London Interbank Offered Rate; its official name is now LIBOR ICE. It’s being phased out and replaced by rates like SOFR and SONIA (Sterling Overnight Index Average). The ICE Benchmark Administration will stop publishing LIBOR for most settings after December 31, 2021. 4 Preqin 5 Refinitiv’s estimate is based on the middle-market loan amounts maturing through 2026. 6 Preqin
Notes and Disclaimers
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities, or an offer, invitation or solicitation of any specific funds or the fund management services of Oaktree (as defined below), or an offer or invitation to enter into any portfolio management mandate with Oaktree. Any offer of securities or funds may only be made pursuant to a confidential private placement memorandum, subscription documents and constituent documents in their final form. The term “Oaktree®” used herein refers to Oaktree Capital Management, L.P.™ or its affiliates, individually or collectively, as the context requires. This document is being provided on a confidential basis solely for the information of those persons to whom it is given. The materials, including the information contained herein, may not be copied, reproduced, republished, posted, transmitted, distributed, disseminated or disclosed, in whole or in part, to any other person in any way without the prior written consent of Oaktree. By accepting this document, you agree that you will comply with these confidentiality restrictions and acknowledge that your compliance is a material inducement to Oaktree providing this document to you. Responses to any inquiry that may involve the rendering of personalized investment advice or effecting or attempting to effect transactions in securities will not be made absent compliance with applicable laws or regulations (including broker dealer, investment adviser, or applicable agent or representative registration requirements), or applicable exemptions or exclusions therefrom. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Further, Oaktree makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Oaktree believes that such information is accurate and that the sources from which is has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Moreover, independent third-party sources cited in these materials are not making any representations or warranties regarding any information attributed to them and shall have no liability in connection with the use of such information in these materials.
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What should I know for a Private Debt/Direct Lending Interview?
I have an interview at a large private debt house (in the UK) and I have been tasked with a case study as the first part of the interview.
Private debt/direct lending seems to be a bit mysterious on the internet, and I'm not totally sure what models/tools are typically used by private lenders in the industry.
Are there any analysts who have worked in this sector that are willing to share some insight into the hard skills commonly used on the job, and those that I should drill before my interview?
Any tips would be really appreciated!
What position is this for? Analyst/Associate? The critical model here you need to understand is the LBO model, but the key difference here is youre not solving for returns but you are rather using the LBO model to understand if there is debt service capability in the entity whose instruments you are investing in.
Private debt / direct lending can take many shape of forms CLOs, funds with distressed strategies, and or traditional PE/Sponsor houses with a separate credit focused fund / arm. You usually buy into the debt of levered corporates (sub investment grade) and help fund a chunk of LBO financing. Typical instruments involve Term Loan Bs and High Yield Bonds with various levels of debt seniority.
Pretty well versed in the credit space given I come from a Lev Fin background, so if you want, PM me the fund name and I can give you more clarity.
Thanks for your reply! The role is an an entry level analyst. I'll PM you with some more info
Work at a large private debt house in the UK myself.
I don't really think private debt is that different from any other kind of lending, you work for a different type of firm but at the end of the day you're basically a bank.
In terms of interview, be prepared for:
Talk about what sort of sectors/assets are doing well at the moment and which ones are struggling, meaning which ones would you lend against and which ones not.
Know of some of the key metrics that are relevant to your asset class, and what sort of due diligence would you do on a new deal. This would be specific to your asset class, i.e are you a lending to companies, real estate, infra debt, special/distressed situations, etc.
You need to know your modelling. Basically credit is all about looking at things that could go wrong and seeing what sort of stresses your loan can take.
Thank you for your reply!
When you refer to modelling, do you mind expanding on what sort of models are commonly used?
I have been tasked with a case study, in which EBITDA, Revenue, Net Debt and the Interest coverage ratio are all provided. I have no information on peers.
Please forgive my ignorance, but are there any calculations or models that you would use to assess or determine the terms of a loan agreement with said firm? I don’t have that much experience in the credit research space so apologies if that is obvious, I clearly need to do some homework, but any pointers you can give me on what to look at would be really appreciated !
Would be similar to corporate banking albeit the debt is most likely subordinated and potentially tranched. See if you can find anything on credit analysis for corp banking / mezz debt. One private lender I know of in my city also likes to attach equity kickers to their debt so also be aware that that is also on the table.
Edit: My comparison here is incorrect: please see following comments for clarification
Not to be rude, so sorry if this sounds brash, but this is completely dis-similar from corporate banking/relationship management. And the debt here is not "likely" to be subordinated, depending on the lender/funds strategy or investment mandate, the lender/fund here could invest in only super-senior secured debt, and most leveraged loans for first time issuers as well tend to generally be senior to all other claims on the cap structure and pari passu ranked to an RCF if there is one.
Albeit there are some overlapping traits when it comes to baseline credit credit, but imo thats where it ends as even the nature of the docs tend to be more comprehensive than relationship facilities traditionally provided by corporate banking
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Direct Lending
Canadian Public Pension Fund
Engagement at a glance
This Canadian public pension plan was seeking to redeploy capital being returned from previous private debt investments (with which bfinance had also assisted) in the US and Europe. They hoped to invest with one or two private debt managers in North America or Europe ($50 million per manager), targeting a 7-11% net return.
This client was uncertain about the types of private debt strategy that they wanted, making flexibility and education particularly important. During the middle stages of the direct lending search the investor decided to avoid unsponsored loans and junior debt, having initially been open to these at the onset of the project. Yet deeper understanding of the managers and their processes ultimately led them to select funds with significant exposure to these sectors. The investor was also concerned about the speed of deployment, the managers’ allocation policies and how quickly capital would be returned to them, and had a strong preference for managers with a lead origination style.
The investor ultimately selected two managers that would have been excluded by a more simplistic approach.
- bfinance issued a customised RFP for this investor, encompassing a range of strategies including lower middle market, middle market, sponsored and sponsorless loans in Europe and the US. Out of the 76 managers considered, 38 were examined and 21 scrutinised in more detail.
- After the initial RFP, the client expressed a preference to adjust the criteria further, focusing on sponsored loans and funds with a larger proportion of senior/unitranche deals, and to limit leverage to 1x.
- While the analysis was adapted accordingly, bfinance also advised giving further consideration to a handful of managers that did not fit the adjusted requirements due to significant sponsorless/junior debt exposure. Our specialists considered them to be particularly well suited to complement the investor’s existing portfolio and deliver the desired objectives. The investor ultimately selected two managers that would have been excluded by a more simplistic approach (one in opportunistic junior debt, one with a significant proportion of unsponsored lending).
- Making this possible required deep analysis of the shortlisted managers and how they would fit within/diversify the existing portfolio, board education , and intensive due diligence Through the process the client became more comfortable with sponsorless loans and junior debt , particularly in view of the diversification characteristics and the processes of the particular managers involved.
- Serious consideration was given to the allocation policies of the managers to determine how quickly the investment may be deployed and how loans are allocated to the relevant vehicles (fund, SMAs, part of BDC etc). Conflicts of interest can arise and allocation polices are not well documented by many private debt managers.
- Supported by bfinance analysis of US and European private debt markets , the investor ultimately preferred to focus on US opportunities due to manager track records, GDP predictions, LIBOR movements, loan issuance figures and more. They are likely to revisit the European private debt market as the situation evolves.
Our specialist says
This case study demonstrates an important point: even when an investor has reached the stage of looking for managers, there is often a uncertainty regarding the appropriate strategies, portfolio composition and so forth. Educating the board, approaching the engagement creatively and working flexibly with the investor to provide different forms of analysis were all important here. In addition, this example shows how deeper understanding of the asset managers available in a particular sector can greatly affect the investor’s opinion on how comfortable they are with the relevant sub-strategies.
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Private Credit Recruiting (What to Expect and How to Prep)
The financial crisis of 2007 - 2008 permanently changed how the leveraged finance arms of investment banks operate. Regulatory guidelines enacted in response to the financial crisis and decisively limited the banks’ ability to lend to companies in risky sectors or finance risky leveraged buyouts to support their private equity clients.
As banks became more selective about the transactions they supported, Private Credit (i.e. Private Debt or Direct Lending) emerged to fill the significant lending gap that the investment banks left behind. Private Credit has grown to become one of the most important segments of the entire debt financing universe.
Despite the surge of popularity in private credit among young professionals, there are very few resources explaining how those interested in a career for private credit can navigate its mystifying recruiting process.
In this post, we will provide an overview of how recruiting for private credit works, discuss the similarities and intricacies compared to private equity recruiting, and provide a guide on how professionals from different career backgrounds can navigate the process.
Overview of Private Credit
Similar to private equity, recruiting for private credit is composed of 4 to 5 rounds of interviews, which include a round dedicated to a case study and/or model test. Interviews consist of technical, behavioral and fit questions, with technical questions being geared towards debt- or credit-related topics.
The recruiting season typically begins one year later than private equity, starting in late Fall of an analyst’s 2nd year, although many funds, especially smaller ones, will just recruit on a need basis. As such, we would estimate that Private Credit has more off-cycle recruiting opportunities than Private Equity.
Paths to Private Credit
The most common path to getting an interview at a private credit fund is through headhunters who usually reach out directly to analysts through your professional email.
The largest credit funds such as Carlyle, KKR (both Henkel), Oaktree (Amity) and GSO (SG Partners) rely on the headhunters they use for private equity recruiting. Many private equity mega funds have large credit arms. Regional or smaller funds (<$5B AUM) often post directly to job sites or use lesser known recruiters. When speaking with headhunters, make sure to have your story nailed down as to why you are pursuing private credit over private equity.
Opportunities are available to anyone working in investment banking, but the most common paths to Private Credit are candidates from:
Leveraged Finance or “LevFin” (origination, underwriting, execution)
Capital markets
Corporate / commercial banking
For those not currently in any of these fields, it is highly recommended that you lateral to one first in order to get related work experience and better access to recruiting pipelines.
For commercial and corporate banking analysts finding it difficult to get interviews, a common path is to transition into a LevFin group (whether internally or lateral) before recruiting.
Contrary to private equity, it is not uncommon to see analysts that were promoted to associates in investment banking also move to private credit.
Typical Credit Interview Questions
When preparing for Private Credit interviews, you should take special attention to understand your deals very well. You should be able to:
Explain in 30 seconds what the company does and how their business model makes money.
Know key stats of the transaction (size and interest rate on each debt tranche, leverage metrics) and business (EBITDA, cash flow/margin profile, etc.).
Discuss the investment highlights (what makes this company a good business to invest in?) and risk and mitigating factors (what risks could impact the business’ performance and how is an investor and the company’s cash flows protected?).
If it was a LevFin deal, know details of the syndication process and what investors were concerned with (if possible, check if the credit fund potentially looked at any of the deals you worked on).
If you have directly related experience, you will likely be asked about credit-related technicals, such as:
How do you calculate financial covenants (e.g. Fixed Charge Coverage Ratio)
How do you calculate all-in yield for term loan or bond?
Walk me from EBITDA to levered free cash flow
Walk me through a credit agreement
What is your view on the leveraged loan market?
If you have a corporate or commercial banking background, expect to be grilled more on technicals and what exactly your responsibilities were on deals. Some interviewers assume corporate bankers just manage client relationships and do not handle technical analysis like LevFin juniors, so the technical standard is often higher.
The Case Study / Model Test
The majority of Private Credit groups will administer a case study as the next portion of the interview process.
The case study will either be a take-home assignment or an in-person test. Take-home assignments are much more common during the off-cycle, while in-person tends to be more common during on-cycle due to the time constraints.
1. Take-Home
You will be given a CIM or presentation on a company and supplemental information including an industry report or excel files with large data sets that you will need to comb through.
You will have 2-3 days to prepare a presentation either in Word or PowerPoint format. It should outline the transaction situation, company and its business model, investment merits, key risks and mitigating factors, historical financial analysis, a projection model with multiple cases and most importantly, your recommendation on if you would do the deal or not (Hint: It’s okay to recommend not doing the deal as long as you can defend why).
You will present your memo in front of a group of people who work at the fund. Expect to be grilled on your thesis (Hint: even if it’s a stellar deal, people in the room will try to scrutinize your analysis to see how you handle pressure). You should also be prepared to talk through a downside case .
The idea is to simulate a real investment committee where decision-makers will ask very tough questions to make sure your thesis is air-tight before they approve your deal.
2. In-Person
This will be similar in structure, except that you will only have 3-4 hours to prepare and present your presentation at the fund’s office. Your write-up will be a slimmed-down summary of the take-home version, so 2-4 pages of analysis plus a short form cash flow projection model (i.e. no full balance sheet).
A case study is similar to the work you do during a credit underwriting process (i.e. putting together an 80-page memo and presenting it to the bank’s risk committee).
Every bank runs its credit processes differently, so if your group is not involved with credit underwriting, we suggest taking a CIM from a deal you’ve worked on and preparing your own investment memo.
Example of a Summary Cash Flow Model Output
Some funds may administer a separate model test depending on their investing mandate. Some firms only invest in first-lien term loans, while others invest all throughout the capital structure. Capital structure-focused funds often have higher technical standards and may have a more complex model assignment.
This involves building a full three-statement model from scratch within 2-3 hours using provided financial and capital structure assumptions. Expect to calculate credit ratios and run an IRR analysis if the fund invests in mezzanine or equity co-investments.
While the talent pool for Private Credit and Private Equity recruiting may be similar, the technical standards needed for Private Credit tend to be different. Not only do you have to build three-statement cash flow models, but you also need to be able to compute credit financial ratios, understand debt documents, and analyze individual tranches of debt. The interview fundamentals may be the same, but you may need to spend more time understanding the technical nuances.
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direct lending interview questions
Ive been asked quite a bit to write about distressed debt interview questions and more generally about how to think about distressed investing. So since credit markets are absurdly tight, theres an excess of capital sloshing around chasing any modicum of yield, etc. I have some free time so I figured Id walk through some questions.
Before beginning, Ill just say what you probably already know: credit recruiting in general is quite ad hoc relative to other areas of the buy-side (like private equity if youre coming out of M&A).
Speaking in the most general terms, whether your recruiting for a position in direct lending, private credit, or distressed debt you should expect a series of pretty ad hoc interviews – that will be both fit and technical – followed by a modeling test or case study of some kind (itll vary as to what the test or case entails, unlike in PE where its pretty predictable and standardized).
While I hesitate to make any sweeping generalizations, I would say when you think about the structure of credit buy-side recruiting you should anticipate having somewhere between five and eight roughly 30-minute rounds of interviews that will be primarily one-on-one.
If we assume there are six rounds, then the first four are likely to be one-on-one sit-down interviews. These will look more or less like what you went through in banking. However, the primary difference is that while in banking youre getting quite a few short questions that have relatively objective answers, for distressed debt or special situation interviews these will feel much more like intelligent conversations that will flow relatively naturally.
In these one-on-one interviews – I mean, maybe some will be two-on-one, but whatever – youll certainly get some fit questions, but most of how you will be evaluated on fit will come through how you articulate your answers to relatively broad questions surrounding your background, deals, why distressed debt, etc.
For example, when discussing a deal you worked on are you articulate and succinct? Are you skewing your answer toward what a distressed debt investor is most interested in, as opposed to what a banker would be most interested in? Did you consider how a distressed debt hedge fund was thinking about their 2L position, even though you were advising the debtor so didnt necessarily need to that much? And, just as importantly, do you seem at all interested in discussing the deal and have some general level of enthusiasm?
You will likely be asked some more pure “technical” interview questions as well. Depending on your background – especially if youre coming out of a non-restructuring job – you may get some that have quite objective answers. For example, whats contained in a plan of reorganization (POR)? What out-of-court solutions exist for a troubled debtor? What kind of consideration could you receive as part of a Chapter 11?
With that being said, most technical interview questions will be slightly more open-ended and difficult (which is what well be going over in this post).
Like with everything in the realm of restructuring and distressed debt, reasonable people can disagree about almost everything. What your interviewer is looking to see is that you have thought about how someone on the buy-side would think about the question, can articulate your answer in a definitive and reasonably persuasive manner, and that you arent caught completely blind by the very nature of the question.
Moving on, the final few rounds of the interview process will involve some kind of modeling test or case study. Normally theres a bit of modeling and then a few slides you have to create pitching buying (or not) a certain part of the capital structure.
While every firm will view these differently – and give different tests / cases – I think its fair to view these as more of a competency test. I think (generally) you can view it as a bar to hurdle as everyone knows these arent overly representative of the work done in practice. Its more about showing that you have the capacity to model and then put some thoughts to paper in a limited time frame than showing that you are some kind of modeling savant.
Most often, youll have one “round” where an interviewer just pokes around your model and slides, asks some questions, etc. Then another round will follow where an interviewer – or group of interviewers – will hear you walk through what youve done, etc. Theyll probably be quite aggressive and contrarian, because thats what you should expect in investment committee meetings anyway.
My personal view – which, again, may not extend to everyone else! – is that probably the most important thing to do when youre doing these tests or cases is to make sure you have a slide or two going over “Additional Considerations”.
Because you definitely wont have the time to go through – or perhaps even be given – all the credit docs, etc. you should make reference to what else youd want to look at before making a definitive decision. You should frame the investment youre choosing (or not) as a kind of initial indicative decision, subject to change based off of these “Additional Considerations” youve laid out.
Because any test or case study is necessarily stripped down and simplified, you want to show that you understand what additional things youd need to consider. If nothing else, this will help buffer any deficiencies in what you actually did (e.g. “Well they missed a few things, but they had some good points for what else to consider, so chances are if they had more time they wouldve picked up some of the things they missed as well”).
Note: Some firms are more apt to do the test or case upfront — especially if they view it as just being a hurdle to weed out candidates.
Obviously in banking there are some questions that everyone gets asked and this is more or less the way you compare and contrast candidates.
On the buy-side – at least in the distressed world, in my view – questions are asked much more with an eye toward your process of answering, what you prioritize including in answers to open-ended questions, etc. as opposed to just being expected to give a definitive one-sentence answer.
The following interview questions arent necessarily ones that you will invariably get if you interview across enough distressed debt funds. Rather, Ive put these together to kind of be a representation of what style of questions you can expect and so you can see what theyre testing.
Id treat these as being indicative, not illustrative, and as a way to help prod your thinking on areas where perhaps you havent given much thought.
When asked questions like these, I wouldnt restrict yourself to a one or two minute answer like you may in banking. Chances are these questions will spark follow-up questions and a conversation will more naturally develop.
Direct Lending and the Private Credit Craze | Private Capital
What is Direct Lending?
Direct Lending Definition: Direct lending funds provide loans to middle-market companies that are originated and held by the lender rather than broadly syndicated; they are typically illiquid, senior secured loans with 5-7-year maturities and floating coupon rates, and returns expectations are in the high single digits to low double digits.
Just like private equity funds, direct lending (DL) funds raise capital from outside investors (Limited Partners) and then charge a management fee and incentive fee (carry), with a hurdle rate requirement to earn the incentive fee.
Unlike commercial banks, DL funds are unregulated, which means they can take higher risks and pursue deals that large commercial banks would reject or ignore.
Often, the financing required for middle-market M&A and buyout deals is in the “grey zone” for banks: it’s too large for the bank to fund directly but too small to be worth syndicating (i.e., splitting up the issuance and selling it to other investors).
So, instead of negotiating with several banks for a $150 million term loan, a company might find a direct lender that can fund the entire loan and complete the process quickly.
DL funds can also make deal processes more efficient by reducing the number of parties involved and the risk of leaks about the deal.
They’re often willing to lend up to higher multiples of EBITDA (e.g., 4.5x or 5.0x rather than 4.0x for a Term Loan)… in exchange for higher interest rates, of course.
I’ve used this before, but this graph from Marquette Associates sums up various credit fields quite well:
Direct Lending vs. Private Debt
These terms are often used interchangeably, but private debt is broader and includes direct loans, mezzanine, and forms of distressed debt.
“Private debt” means that the loan is funded directly by one investment firm rather than being syndicated and sold to many investors, and that that one investment firm plans to hold the loan until maturity.
Also, as the name implies, private debt is not publicly traded, so its market value is more difficult to determine.
But the terms, risk, and returns expectations for private debt vary widely, and distressed debt, at one end of the spectrum, is not comparable to the average direct loan.
Overview of Private Credit
Similar to private equity, recruiting for private credit is composed of 4 to 5 rounds of interviews, which include a round dedicated to a case study and/or model test. Interviews consist of technical, behavioral and fit questions, with technical questions being geared towards debt- or credit-related topics.
The recruiting season typically begins one year later than private equity, starting in late Fall of an analyst’s 2nd year, although many funds, especially smaller ones, will just recruit on a need basis. As such, we would estimate that Private Credit has more off-cycle recruiting opportunities than Private Equity.
Private debt/direct lending seems to be a bit mysterious on the internet, and Im not totally sure what models/tools are typically used by private lenders in the industry.
Are there any analysts who have worked in this sector that are willing to share some insight into the hard skills commonly used on the job, and those that I should drill before my interview?
I have an interview at a large private debt house (in the UK) and I have been tasked with a case study as the first part of the interview.
What is direct lending in finance?
Direct lending is the provision of credit directly to small and middle market companies (SMEs) for growth or acquisitions . With mainstream banks reducing their supply of loans, new sources of finance have developed.
What are the advantages of direct lending?
The Top Direct Lending Funds
In the first category are firms like Ares, Goldman Sachs Merchant Banking, Apollo, Bain Capital, KKR, Blackstone (GSO), Cerberus, Fortress, and Centerbridge .
What is direct and indirect lending?
The growth of direct lending has enabled mid-sized businesses and lenders to prosper from favorable terms, greater term flexibility, high yields and negotiable risk . Middle market businesses are far more likely to secure a sizable loan from a direct lender than from a traditional financing institution.
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Distressed debt interview questions and interview format.
I've been asked quite a bit to write about distressed debt interview questions and more generally about how to think about distressed investing. So since credit markets are absurdly tight, there's an excess of capital sloshing around chasing any modicum of yield, etc. I have some free time so I figured I'd walk through some questions.
Before beginning, I'll just say what you probably already know: credit recruiting in general is quite ad hoc relative to other areas of the buy-side (like private equity if you're coming out of M&A).
Distressed Debt Interview Format
Speaking in the most general terms, whether your recruiting for a position in direct lending, private credit, or distressed debt you should expect a series of pretty ad hoc interviews - that will be both fit and technical - followed by a modeling test or case study of some kind (it'll vary as to what the test or case entails, unlike in PE where it's pretty predictable and standardized).
While I hesitate to make any sweeping generalizations, I would say when you think about the structure of credit buy-side recruiting you should anticipate having somewhere between five and eight roughly 30-minute rounds of interviews that will be primarily one-on-one.
If we assume there are six rounds, then the first four are likely to be one-on-one sit-down interviews. These will look more or less like what you went through in banking. However, the primary difference is that while in banking you're getting quite a few short questions that have relatively objective answers, for distressed debt or special situation interviews these will feel much more like intelligent conversations that will flow relatively naturally.
In these one-on-one interviews - I mean, maybe some will be two-on-one, but whatever - you'll certainly get some fit questions, but most of how you will be evaluated on fit will come through how you articulate your answers to relatively broad questions surrounding your background, deals, why distressed debt, etc.
For example, when discussing a deal you worked on are you articulate and succinct? Are you skewing your answer toward what a distressed debt investor is most interested in, as opposed to what a banker would be most interested in? Did you consider how a distressed debt hedge fund was thinking about their 2L position, even though you were advising the debtor so didn't necessarily need to that much? And, just as importantly, do you seem at all interested in discussing the deal and have some general level of enthusiasm?
You will likely be asked some more pure "technical" interview questions as well. Depending on your background - especially if you're coming out of a non-restructuring job - you may get some that have quite objective answers. For example, what's contained in a plan of reorganization (POR)? What out-of-court solutions exist for a troubled debtor? What kind of consideration could you receive as part of a Chapter 11?
With that being said, most technical interview questions will be slightly more open-ended and difficult (which is what we'll be going over in this post).
Like with everything in the realm of restructuring and distressed debt, reasonable people can disagree about almost everything. What your interviewer is looking to see is that you have thought about how someone on the buy-side would think about the question, can articulate your answer in a definitive and reasonably persuasive manner, and that you aren't caught completely blind by the very nature of the question.
Moving on, the final few rounds of the interview process will involve some kind of modeling test or case study. Normally there's a bit of modeling and then a few slides you have to create pitching buying (or not) a certain part of the capital structure.
While every firm will view these differently - and give different tests / cases - I think it's fair to view these as more of a competency test. I think (generally) you can view it as a bar to hurdle as everyone knows these aren't overly representative of the work done in practice. It's more about showing that you have the capacity to model and then put some thoughts to paper in a limited time frame than showing that you are some kind of modeling savant.
Most often, you'll have one "round" where an interviewer just pokes around your model and slides, asks some questions, etc. Then another round will follow where an interviewer - or group of interviewers - will hear you walk through what you've done, etc. They'll probably be quite aggressive and contrarian, because that's what you should expect in investment committee meetings anyway.
My personal view - which, again, may not extend to everyone else! - is that probably the most important thing to do when you're doing these tests or cases is to make sure you have a slide or two going over "Additional Considerations".
Because you definitely won't have the time to go through - or perhaps even be given - all the credit docs, etc. you should make reference to what else you'd want to look at before making a definitive decision. You should frame the investment you're choosing (or not) as a kind of initial indicative decision, subject to change based off of these "Additional Considerations" you've laid out.
Because any test or case study is necessarily stripped down and simplified, you want to show that you understand what additional things you'd need to consider. If nothing else, this will help buffer any deficiencies in what you actually did (e.g. "Well they missed a few things, but they had some good points for what else to consider, so chances are if they had more time they would've picked up some of the things they missed as well").
Note: Some firms are more apt to do the test or case upfront -- especially if they view it as just being a hurdle to weed out candidates.
Distressed Debt Interview Questions
Obviously in banking there are some questions that everyone gets asked and this is more or less the way you compare and contrast candidates.
On the buy-side - at least in the distressed world, in my view - questions are asked much more with an eye toward your process of answering, what you prioritize including in answers to open-ended questions, etc. as opposed to just being expected to give a definitive one-sentence answer.
The following interview questions aren't necessarily ones that you will invariably get if you interview across enough distressed debt funds. Rather, I've put these together to kind of be a representation of what style of questions you can expect and so you can see what they're testing.
I'd treat these as being indicative, not illustrative, and as a way to help prod your thinking on areas where perhaps you haven't given much thought.
When asked questions like these, I wouldn't restrict yourself to a one or two minute answer like you may in banking. Chances are these questions will spark follow-up questions and a conversation will more naturally develop.
Question 1: Let's say we're looking at a company with a Term Loan trading at par due January 2023, Senior Notes due July 2021 trading at 85, and Senior Notes due January 2023 trading at 70. What would you estimate the max downside risk of the July '21 Notes to be?
Question 2: Let's say this capital structure now has Subordinated Notes as well and they're trading at 50. Let's say you like the idea of buying the July '21 Senior Notes, but want to hedge your exposure within this capital structure in some way. How would you think about doing that?
Question 3: Let's say we do go long the '21 Notes and short the Subordinated Notes. What do we need to be careful here?
Question 4: Non-pro rate uptiers have obviously been a big story line in the distressed debt world over the past year. What do you think of them?
Let's say we're looking at a company with a Term Loan trading at par due January 2023, Senior Notes due July 2021 trading at 85, and Senior Notes due January 2023 trading at 70. What would you estimate the max downside risk of the July '21 Notes to be?
This is a typical question in that there's no objective answer necessarily (who knows what is truly ever baked into debt pricing and what the ultimate downside will be in the future?), but we can ramble on for quite a bit of time about this and circle around a potential answer.
Note: Let's pretend the we're looking at all of this at such a time in which the '21s are a year away from maturing and so we'll have a few coupons between now and maturity.
So first of all, let's set the stage a bit. There are a few things that should immediately jump out here.
- Given the current credit environment we have debt trading at levels that are at least stressed if not distressed
- The Term Loan is trading at par, so it is likely fully covered without much issue
- The July '21 Notes are coming due first and the Term Loan and January '23 Notes are due at the same time (the TL probably springs before the Notes)
- Despite the pari status of the Notes in the event of filing, we see a 15 point spread between the '21s and the 23s
I think the best way to frame the answer to broad questions like this is to begin by stating a simple answer - a kind of best first guess - and then provide complicating factors that need to be considered that could lead to a closer, more real-world answer.
So the simple answer is that the '23 Notes are probably pricing in the recovery value with a touch of optionality (reflecting a potential turnaround in the company's fortunes that would lead to the ability to roll these over in a few years).
What the '21 Notes are pricing is the enhanced probability that given that current state of the company - whatever it is - there's a higher likelihood these will be able to be dealt with.
In other words, the spread between the '21 Notes and '23 Notes is likely reflecting a scenario where the '21 Notes have a good shot at being refinanced, but that the '23 Notes will probably not when they come due (thus they're trading at more or less what their recovery value would be should filing occur).
Simplistically, if we assume just two outcomes - refinancing of the '21 Notes or filing before maturity - then we can say the market is pricing in a 50% probability of either happening as 50%*0.70+50%*1.0=0.85 (this assumes the actual recovery value is just the market price of the '23 Notes).
Therefore, carrying this simplistic example forward, we can think of the potential upside as involving buying at 85 and getting back par. Similarly the potential downside would be buying at 85 and getting back 70 in recovery. Therefore, the max downside would be 15 cents on the dollar.
However, this is all a bit too simple! There are obviously a few nuances that should be considered.
First of all, is our downside really 15 cents on the dollar if we buy at 85? Even assuming we're certain (for whatever reason) as to the recovery value being 70, what about the coupons we'd be clipping between now and when filing occurs? They need to be blended in because chances are you wouldn't have the company file immediately after buying the Notes at 85 (or before the first coupon is clipped). So, the actual downside would be some amount lower than 15 cents.
The other nuance to consider is our belief that the '23 Notes are pricing in the recovery value. Chances are the recovery value is actually lower than what is priced into the '23 Notes as the '23 Notes will have some level of optionality reflected in the price (as previously mentioned). This optionality is not just reflective of the potential capacity for the company to turn things around, but also reflective of perhaps the belief that the '21 Notes will be dealt with before filing occurs so that the impaired class would just be the '23 Notes (not the '21 and '23 Notes in the same class, diluting down the recovery values for all holders).
So, when thinking about the max downside risk to the '21 Notes we know it will be whatever their recovery would be in the event of filing. We can say this is certainly some non-zero value as the term loan is trading at par and the Senior Notes are the only things behind the Term Loan.
For the purposes of the '21 Notes max downside, we would need to assume filing occurred when both were outstanding so you have both pari tranches getting recovery. We can't per se look to the '23 trading levels as reflecting filing happening when both are outstanding, as one could imagine them pricing in a) optionality of a full company turnaround that allows both tranches to refi and b) the recovery level that would be obtained if the '21 Notes are dealt with before filing.
So, a more fulsome picture of what the true max downside is would need to be obtained by modeling out the company and making your best guess as to the recovery value if filing were to occur prior to maturity of the '21 Notes. Chances are, we'd come up with a downside between 13 and 20 cents. The fact that 13 cents (which is just an illustrative number, since we haven't actually assigned any coupons here) is less of a downside than the 15 cents priced between the '21 and '23 would reflect being able to clip some coupons before filing occurs and then getting a 70 cent recovery, which would be the best case scenario. In other words, the 70 price of the '23 Notes is probably the ceiling on any recovery value.
Note: You may look at this little cap structure and say obviously the company will try some out-of-court solution. That's probably true! But remember, we're just looking to our max downside risk and an out-of-court solution involving the '21 Notes would probably be providing us a level of compensation well in excess of ~70 cents on the dollar (probably closer to where the '21s are trading now give or take). So our max downside must involve the company filing.
Let's say this capital structure now has Subordinated Notes as well and they're trading at 50. Let's say you like the idea of buying the July '21 Senior Notes, but want to hedge your exposure within this capital structure in some way. How would you think about doing that?
Taking a step back, if we're interested in buying the '21 Notes then the rationale behind it is obvious: we think these Notes will be able to be refinanced.
So our belief is that we'll be able to clip some coupons and pick up 15 points when the Notes mature, which provides a great YTM (I mean, we haven't specified a coupon rate for anything in this little capital structure, but even if it was absurdly low it'd still provide a great YTM in the current credit environment given where the '21 Notes are trading now).
Now what risk are we really trying to hedge here? Obviously, we're trying to hedge the risk of the '21 Notes not being refinanced, but instead the company filing prior to that event. As we discussed in the last question, the '21 Notes would then fall pari with the other Senior Notes due in '23 and provide a recovery significantly below where the '21s are trading now (and probably below where the '23 Notes are trading too).
Now if we're looking to hedge our exposure - operating within this capital structure - then we first need to find the most ideal part of the capital structure that would move the most in the event of a default.
Hypothetically, we don't care if our hedge position moves down or up a lot as we can express our hedge via a functionally long or short position. We just want to find a hedge that:
- Will provide the largest gain in the event of a default (offsetting our losses at least partially on how our long '21 Notes position will fall)
- Will not be too costly to execute at initiation and to hold
- In the event the 21' Notes are refi'ed we don't want our hedge to move so negatively that it offsets our gains as well
If we think about this little capital structure, what would we expect to move the most in the event of a default? Chances are it will be the tranche of debt that has the highest level of "optionality" priced into it.
If we think about the TL, there's really no optionality priced in. If the company magically becomes the picture of ideal health, the TL will probably trade around par like it is now.
However, when we begin moving down the capital structure more and more of the price we see in the market will reflect the optionality of the company potentially turning things around (as these areas of the capital structure will provide for larger gains should a turnaround occur).
This is most evident, obviously, when we look at equity for a distressed company where you have a very clear asymmetric profit profile. If you buy equity - when the debt above you is significantly distressed - you know when the company files you'll almost certainly have no recovery, but if the company does turn things around you could expect equity to trade up many multiples. A real-world example of this is Tupperware, which went from $1.15 in March 2020 to ~$32 at year end after skirting needing to file after it appeared likely they would (the most junior part of the capital structure trading below fifty cents on the dollar at one point).
The same holds true for debt, but of course debt has a more obvious upper-bound on how high it could ever trade up.
So if the lower down the capital structure we go, we find more optionality priced in then we'd expect in the event of default for the lowest parts of the capital structure to trade down the most all things being equal.
Perhaps another way to say this is that you can consider debt trading levels the further you go down the capital structure as becoming more and more detached from what the recovery value will actually be. Or, said yet another way, as you move down the capital structure there will be more optionality premium layered over the market consensus for what the recovery value of the tranche will be. This premium, of course, is extinguished when filing becomes evident.
So one would imagine (probably!) that the piece of the capital structure (excluding equity) that will move down the most in the event of filing will be the Subordinate Notes. This is because it is probably trading at a premium due to outsized gains that could occur if the company turns things around or is able to forestall filing by dealing with the '21 Notes.
Therefore, the trade we could do within the current capital structure is going long the '21 Notes (expressing our bullish view on refinancing these) and hedge this by going short the Subordinated Notes (since they will likely fall the most in the event of filing, given that the optionality premium will evaporate).
Note: Of course, we could also go short the equity if it's publicly traded as well since it will have the sharpest reaction to a filing. But I'm assuming we're dealing with the capital structure in the strictest sense of the word for this question.
Let's say we do go long the '21 Notes and short the Subordinated Notes. What do we need to be careful here?
The obvious thing to be mindful of here is that we're dealing with a negative carry scenario.
Although I haven't specified what the coupon rates are for anything in this capital structure, it's safe to say the Sub Notes are going to have a much higher coupon than the Senior Notes.
So let's say the Sub Notes have a coupon of 8% and the Senior Notes have a coupon of 4%. We're clipping coupons on the 4%, but having to pay out the 8% coupons.
As long as we have this trade on we are dealing with a negative carry of 4%. Assuming that over a year no prices on either of these tranches of debt are moving, then we're just bleeding money.
Now given how I've set up the question, this isn't a huge deal as the catalyst for the trade (refi or not) will take place in a year so we won't be bleeding this negative carry over a prolonged period of time.
But with that said, you should be mindful of how this hedge is dampening returns. If our thesis proves true, then the Sub Notes will probably increase in value (as the '21 Notes being refi'ed will almost certainly be good news for the Sub Notes prospects) and we will be paying negative carry.
If our thesis does not prove to be true, then we'll have a sharp decline in the '21 Notes we're long, a gain in the Sub Notes that trade down, and we will still be paying negative carry.
So the fact we're paying negative carry dampens down the upside potential of the trade and adds insult to injury should the trade not go our way (although, of course, negative carry is the price you pay to have the hedge, which dampens the max negative returns you'd get in this scenario).
Of course, how much this effects our returns is contingent on how large of a hedge we're dealing with here.
If we're dealing with a YTM of ~21% on the '21 Notes - assuming a year to maturity and a 4% coupon - then we may be reluctant to engage in any hedge that limits our upside to anything below a 14% IRR.
If we think we the company won't file until after a few coupons have been clipped, then that income dampens down the max downside risk.
So, if we think the recovery is - just to throw out an example - 70 cents on the dollar, but we'll be able to clip two coupons, then our IRR would be ~(15%) if the company files. So we already have a bit of asymmetry between the downside (-15%) and upside (+21%) due to the coupon income embedded in this trade.
If placing a small hedge within the capital structure - that has negative carry - causes our range of outcomes to go from +21% / -15% to +14% / -10% then maybe we have enough conviction in the trade (assign a high enough probability to the refi occurring) that we roll the dice without a hedge since we don't want to crimp our upside too heavily.
Non-pro rate uptiers have obviously been a big story line in the distressed debt world over the past year. What do you think of them?
This question is emblematic of the kind of open-ended, more conversational style that many interviews can devolve into.
I could ramble on this subject in a number of different directions for far too long, but I'll try to keep it short given how long this post already is and try to provide a more interesting take.
Many have commented that the case of Serta - where we saw a non-pro rata uptier done - is indicative of the increased "creditor on creditor violence" we've seen over the past few years.
I mean, sure, that's true. But traditionally when we think of creditors battling it out we're talking about more activist distressed funds getting involved as a company heads into distress; jockeying for position, arguing over valuation, fighting over language or priority nuances, etc.
One side of the Serta case had traditional players (Apollo, Angelo Gordon, et al.), but the other side had, uh, mutual funds? Rather robust mutual funds, etc. etc. but still not exactly the kind of classic activist distressed players we're used to seeing.
This strikes me as being a natural out growth of the size these kinds of funds control within the secured tranches of large debtors in general and their realization that they don't need to be entirely passive players through the process.
From a distressed seat, this is troubling as you're faced with needing to be more careful not to get into a position and then get squashed by a large holder - or consortium of similar large holders - who decide they want to more actively dictate a restructuring.
It also poses a challenge in that if you're going to get involved in one of these larger debtors, proposing something controversial, you may need to up the size of your position (which is logistically difficult and likely will lower your return or require more leverage).
As for non-pro rata uptiers themselves, I think it's quite clear that there's no getting around an anti-subordination provision if they exist in the underlying credit docs. So if they exist in credit docs, then worry about something else. If they do exist, pay attention to current holders and think about how you could be blind sided by this kind of transaction.
I think the open-market purchases language argument around non-pro rata uptiers is of more interest in general. I would be curious to see it tested in the courts when it is not so explictly defined in the underlying docs as it was for Serta.
Hopefully this has all been somewhat helpful or at least enjoyable to read. Given that distressed debt and special situations interviews tend to be a bit more conversational and open-ended, I've tried to reflect that in how the questions above were answered.
Of course, for some of these questions you could go on at much more length and perhaps take them in different directions.
For example, while the hedging question limited the type of hedge to being within the current capital structure itself, you could be asked about how you would think about using CDS and how that would work.
I've often been asked to put out a guide - like I did for restructuring - focusing on distressed debt and credit more broadly. While it'd be impossible to create a comprehensive overview guide - given how diverse the buy-side is in credit - I do have fun writing up these questions and talking through my perspective on them.
If you think more of these kinds of questions would be good, be sure to let me know and I'll work away (as time permits) on putting forty or fifty of these questions together in a little guide.
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Super informative would love to see another post on distressed debt questions. Thanks for this write up!
Thanks for the kind words — always makes my day! Probably the closest posts would be the ones on special sits, structural subordination, and rights offerings. I tried to infuse all of them with some interesting side tangents, etc.
this was a fantastic read, and super helpful. are there more blog entries similar to this?
Thanks for the write up man. Very helpful.
Thoroughly enjoyed the read! It would be great if you could post more of buy-side credit related questions! Thanks and cheers
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The interview process is the standard one for any finance role: an HR phone screen or HireVue, a phone or video interview with an investment professional, and then a Superday with 3-4 people at the firm, possibly including a case study or modeling test as well. Direct Lending Fund Interview Questions and Answers
KEY POINTS. Direct lending may generate attractive returns with less downside risk and mark-to-market volatility than more liquid credit strategies like broadly syndicated loans. Debt financing needs could grow in the coming years because middle-market companies face a significant maturity wall and private equity sponsors may drive deal ...
I think the case study itself in terms of format is pretty straight-forward: get a CIM, build a model and do a write-up highlighting business overview, customers, suppliers, go-to-market, industry/competitive landscape, investment merits, key risks & mitigants. Then show sensitivity tables around your model.
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Hi all, I have an interview at a large private debt house (in the UK) and I have been tasked with a case study as the first part of the interview. Private debt/direct lending seems to be a bit mysterious on the internet, and I'm not totally sure what models/tools are typically used by private lenders in the industry.
During the middle stages of the direct lending search the investor decided to avoid unsponsored loans and junior debt, having initially been open to these at the onset of the project. Yet deeper understanding of the managers and their processes ultimately led them to select funds with significant exposure to these sectors.
The majority of Private Credit groups will administer a case study as the next portion of the interview process. The case study will either be a take-home assignment or an in-person test. Take-home assignments are much more common during the off-cycle, while in-person tends to be more common during on-cycle due to the time constraints. 1. Take-Home
Learn how to solve a finance case study and make a recommendation - the type frequently given in technical finance interviews. We build a financial model to ...
Direct Lending Definition: Direct lending funds provide loans to middle-market companies that are originated and held by the lender rather than broadly syndicated; they are typically illiquid, senior secured loans with 5-7-year maturities and floating coupon rates, and returns expectations are in the high single digits to low double digits.
Speaking in the most general terms, whether your recruiting for a position in direct lending, private credit, or distressed debt you should expect a series of pretty ad hoc interviews - that will be both fit and technical - followed by a modeling test or case study of some kind (it'll vary as to what the test or case entails, unlike in PE where …
Ares Direct Lending Case Study The Ares European Direct Lending team was asked to consider supporting the acquisition of a producer of narcotic raw materials and active pharmaceutical ingredients. Despite the strong historical financial performance of the company, the high barriers to entry due to the related nature of the market and a well- ...
Credit Fund Interview Coaching is a personalized 1-on-1 coaching package for candidates recruiting for direct lending, liquid credit, and distressed debt. ... I signed up for a credit-focused case study practice, which was a perfect simulation for my upcoming interview. As a result, I nailed the case study and received an offer from a top ...
How do you prepare for commercial banking interviews and credit tests? What does a commercial banking credit case study look like? In today's video we will c...
U.S. Department of the Treasury
5 "direct lending" interview questions. Learn about interview questions and interview process for 6 companies.
I interviewed at Global Lending Services. Interview. 1. A Case interview for general hire, which is normal but needs more consideration. 2. online assessment, this part is normal, just takes time to finish it. 3. hire manager interview (hard) - include system design I am struggling with it. Interview Questions.
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