While there is no formal definition of a mega or jumbo unitranche, the trend started to gain steam in 2016 when Ares led a $1bn private deal for Thoma Bravo’s take-private of Qlik Technologies. Over recent years, deals four or five times that size have become increasingly common.

But a tightening fundraising environment and increasingly risk-off attitude among many direct lenders is squeezing the market for these chunky private debt transactions, according to multiple private credit sources interviewed by 9fin.

Funds are simultaneously reducing hold sizes and becoming more selective about the deals they participate in, making it harder for borrowers and their advisors to club up enough lenders for deals over $1bn, the sources said.

Even deals upwards of $500m in size have become harder to achieve, as direct lenders prefer to buy smaller portions of deals than they did a few months ago.

“About one and a half to two months ago there was a big change in the market, where it felt like hold sizes across the board did come down,” said John Kline, co-head of private credit strategies at New Mountain Capital.

He also attributed the slowdown in large deal formation to the slower market for syndicated debt, which is enabling lenders to be choosier. Syndicated debt issuance has slowed in recent months, as interest rates rise and large arrangers offer big discounts on underwritten deals.

Some private credit funds are taking advantage of this backdrop, buying widely-traded paper from banks at attractive OIDs rather than participating in less liquid private financings.

As hold sizes come down, it’s becoming easier for smaller companies — which would generally be considered a riskier investment — to find funding in the private credit market than larger, more stable businesses.

“It’s harder to get leverage for a company that does $100m in EBITDA than a company that does $10m in EBITDA,” one banker said. “The market is upside down.”

Risk-off or risk-on?

For some, this dynamic is caused by similar factors to the slowdown in syndicated issuance: risk tolerance is lower as fund managers grapple with rising interest rates and declining equity valuations, and gird themselves for a possible recession.

“There’s a concern about a recessionary environment in general,” said Michael Ewald, global head of private credit at Bain Capital Credit.

He cited the rate backdrop, supply chain disruption and inflation as threats to the economy — even in the face of a strong job market — and noted that lenders are less inclined to write big tickets after the slide in valuations.

“We’ve had a bull run in equity markets and that’s come down, which has led to a pull back from a PE perspective,” he said. “We’re seeing sponsors listing companies for sale, but instead opting to hold onto the business because valuations have come down. That has trickled into private credit, as loan-to-value is also coming down.”

Others suggested the reduction in hold sizes was not a reflection of lower risk tolerance. Rather, they said, direct lenders are investing less money per deal because the slowdown in syndicated markets means there are more deals to choose from.

“If anything it’s risk-on,” said another direct lending executive. “Public markets were an alternative, and now there is no public market. People are spreading it out more.”

The same source said that earlier this year there was a whopping $8bn private credit deal in the works. Ultimately, the M&A transaction it was intended to support fell through — but still, the situation shows how private credit lenders have scaled back their ambitions in recent months.

“Trying to get an $8bn deal would be pretty hard now,” the source said.

Dry powder

Part of the slowdown in bigger deals may also be to do with availability of funds.

With valuations falling, private equity sponsors are less inclined to sell portfolio companies. That in turn means fewer repayments of existing loans, reducing the amount of cash that direct lenders might otherwise be able to recycle into new deals.

“There are very low repayments right now,” said a direct lender focused on large-cap deals. “We have seen a lot of M&A deals get pulled because buyers and sellers can’t agree on valuation, or buyers don’t like the cost of financing.”

The broader fundraising environment for private credit funds has also cooled significantly, sources said — a marked shift from the red-hot demand that has fueled the market’s growth in recent years.

The boom in private credit coincided with years of low interest rates in the wake of the 2008 financial crisis, which pushed investors towards illiquid asset classes in search of yield. Many of those LPs are now reassessing their risk tolerance and return expectations.

“Flows into risk-on assets have gone down,” said Steve Nesbitt, CEO of investment advisor and asset manager Cliffwater LLC. “You’ve seen that across the board.”

Fundraising for direct lending slowed very slightly in the first two quarters of 2021, according to Preqin. Direct lenders raised $26.6bn in 1Q and $25bn in 2Q, down 3% and 10% year-over-year, respectively.

Nevertheless, direct lending funds have still raised a total of $70.4bn so far this year. At that pace, the market looks unlikely to hit last year’s fundraising total of $126.8bn — but it has already beat the $67.6bn that was raised in 2020.

It’s not just LPs that are less bullish. While there are relatively fewer avenues for retail investors to allocate to private credit, the fact that many mom-and-pop investors have pulled money out of the markets in recent months contributes to the overall cooling effect.

“Lenders investing retail dollars have experienced redemptions and there have been outflows from mutual funds,” said Doug Cannaliato, a senior managing director at Antares Capital. ”When you put this all together it results in pressure on capital availability.”

Back to basics

In a sense, the reduction in hold sizes takes the private credit space back to its roots — smaller deals for smaller companies, often the kind of middle-market borrowers that dominated direct lending dealflow before the explosion in supersize unitranches.

“Bigger deals are dead,” said a lawyer focused on the private credit space. “We’re still cranking, but it’s smaller deals.”

Ewald at Bain estimated that the top-end “bite size” for many private credit funds had shrunk from $750m-$1bn to about $250m, noting that investors were less willing to work with together to club up funds.

“Some of the private debt players in the space have lost some co-investors in this current market environment,” he said.

The newfound difficulty of amassing enough capital to get a large deal over the line undermines a major selling point of direct lending: the speed and ease of closing deals.

Under prior market conditions, a financing in the $500m-$1bn range could usually get done with two or three lenders, but that has increased to five or six, said Kline at New Mountain.

“One way to look at it is if you’re looking at a $100m deal, there are plenty of lenders that can do that,” he said. [But] with mega-deals over $1bn, sponsors have to go pretty wide. The hit rate has to be high with a broad group of lenders.”

All of this means that smaller companies are having an easier time tapping the private debt market. Some of them are even able to force competition between lenders on terms such as pricing.

“We’ve seen some deals get done recently that are surprisingly sharp for being small,” one direct lender said.

The catch is that these companies may be more vulnerable to a recession than the larger firms that lenders are shying away from, said Cannaliato at Antares.

“Larger businesses can often have less credit risk because of a more diverse revenue stream, less customer concentration, more pricing power and a proven value proposition,” he said.