Direct lending refers to the growing trend of non-bank lenders making loans to credit-hungry companies without the usual intermediary involvement.

It's a rapidly evolving market, driven by more stringent regulations in the post-financial crisis world. Banks have cut back on business lending and that's created a gap in the market that asset managers, and increasingly peer-to-peer (P2P) lending and crowdfunding platforms, have enthusiastically stepped into. Investors are being drawn in by the attractive returns on offer in an otherwise low-yield environment.

It's a maturing market that's here to stay. European direct lending has grown from a relatively unknown asset class to raising around US$22bn in 2017 alone. According to research by the Alternative Credit Council (ACC), the global direct lending market is expected to break the US$1tn mark by 2020. That's quite a trajectory.

TMF Group has been involved in the direct lending space from the outset. We see a number of factors that will further fuel this nascent market, which were discussed at the recent Creditflux Direct Lending conference in London.

A global game

Whilst behind the more mature US direct lending market (where non-bank lending has almost become the norm), Europe is catching up. Small and medium-sized (SME) companies are looking for alternative finance to fuel their growth as mergers and acquisitions (M&A) picks up across the continent.

Direct lending is also becoming more established in Asia, where asset managers are targeting mezzanine capital which is often overlooked by domestic banks firmly focused on senior debt. In cash-heavy countries, agile P2P and crowdfunding platforms are servicing clients who may not actually be banked with anyone.

Investors across the US, Europe and increasingly Asia see the potential for attractive yields, with low correlation and low volatility to competing asset classes. Loans are generally secured and typically accompanied by upfront arrangement fees.

A growing number of players

The direct lending industry started with asset managers but other types of companies, such as P2P platforms, are now raising funds from investors interested in debt. This is making for a richer, more diverse direct lending ecosystem.

Asset managers tend to focus more on lending to mid-cap companies. They are plugging the gaps left by the banks who, for example, are prohibited from investing in bonds rated below BBB, which are considered high-yield bonds.

P2P platforms and crowdfunding sites also have an important role to play. We're seeing them dominate the €50,000 - €1m loan range . Larger deals are more appropriate for asset managers, who have the necessary scale and risk analysis expertise.

As more money pours into direct lending, fund managers can write bigger loans, which in turn makes direct lending even more attractive. There is also good scope for repeat business, as loans tend to be relatively short term.

The benefits of tightening regulation

Regulatory pressures from the likes of Basel III, and indeed Basel IV, have prompted European banks to retrench and reduce loans to the mid-market. These new regulations aim to strengthen bank capital requirements and decrease leverage, meaning that banks, further constrained from lending, will release a significant portion of market share to the direct lenders.

As direct lenders aren't subject to capital requirement guidelines, they can take on companies with higher leverage, which means more attractive returns for investors.

Tapping into a transforming banking landscape

The concept of open banking is spreading across the world's financial centres like a wildfire. The European Union's (EU) second Payments Services Directive (PSD2) and the UK's Open Banking Initiative, for example, encourage the use of open application programming interfaces (APIs) to provide access to bank customers' transaction data.

These APIs allow third parties, such as fintechs, to access customer data. The belief is that this will allow a wider range of companies to provide a wider range of products and services, driving much-needed competition. It will be interesting to see how much of a boost this will be for direct lenders, who will be armed with increasing amounts of valuable data.

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