Offense or Defense? Direct Lending Can Play Both

A balanced portfolio needs assets with strong return potential and those that may provide downside mitigation. We believe direct lending can deliver both—a potentially valuable feature, particularly in today’s uncertain market.

Investors in direct lending are well positioned to capture outsized risk-adjusted returns today, in our view, while benefitting from features that may reduce downside risk. That ability to play both offense and defense is especially appealing in the current macro environment and underscores the importance of private credit in diversified portfolios.

A Good Time to Play Offense in Direct Lending

On the offense side, we believe now is an opportune time for investors to consider adding direct lending exposure, because higher asset yields have boosted the return potential for the asset class.

A series of aggressive Fed rate hikes has resulted in higher market-wide base rates, which in turn have driven a sharp rise in yields for directly originated loans. Senior secured loans, which are typically floating rate, now yield more than 12%, far above the mid-7% yields seen as recently as mid-2022. In senior secured lending strategies that use portfolio financing, potential net returns now stretch into the low double digits to mid teens, notably above investors' long-term return assumptions. Fed tightening has also limited the credit available to firms of all sizes and altered competitive market dynamics in favor of lenders with available capital and conviction to act. Alternative lenders are well positioned to take advantage of these dynamics: traditional syndicated credit markets have been volatile, and alternative lenders have a longer-term capital base and the ability to execute flexible solutions for borrowers.

Defense Matters in Direct Lending, Too

In investing, as in sports, playing defense is important, too. Direct lending complements its strong offense potential with downside risk reduction potential. That’s important for investors in today’s macro environment, which presents fundamental pressures from inflation levels not seen for generations and a higher degree of uncertainty.

Over time, direct lending has excelled at providing stability during volatile economic environments or periods of market stress. For instance, drawdowns, which measure the decline from a market peak to its trough, were much more severe for public credit markets during the Global Financial Crisis and the COVID-19 pandemic than for direct lending. Since the Federal Reserve began its current tightening cycle in early 2022, direct lending has continued to generate positive returns. (Display).

Smaller Drawdowns: Direct Lending in Recent Periods of Stress