5 Advantages and disadvantages of direct lending.
Passive income has become a prime mechanism for catapulting many to financial success. While there are many means of establishing passive income, investing remains a steadfast solution with the potential for consistent, sizeable returns.
There are a variety of financial instruments through which one can invest their assets, including stocks, bonds, ETFs and futures, but direct lending is becoming a growing trend among many as an investment instrument.
For those who aren’t interested in investment, direct lending can also serve as a capital management strategy that can provide a viable alternative to traditional loans. Understanding the benefits and risks of direct lending can steer potential investors and loan recipients to making a sound financial decisions.
What is direct lending?
The basis of direct lending is that non-bank credit agencies, as well as peer-to-peer lending platforms, extend credit in the form of specific loans to small or midsize entities.
This form of lending has grown in popularity since the 2008 Global financial crisis and is particularly popular in Europe where most lending is controlled by banks rather than capital assets in the US.
Loans acquired are typically used for acquisitions, buy-outs and recapitalizations and growth investments.
Although direct lending most often utilizes first-lien loans, which entitle lenders to collect collateral in the case of defaulting on the loan, second lien debt, unitranche debt and other tranches are also identified as direct lending instruments. There are a variety of attributes that direct lending loans share.
Although some loans can be up to 7 years in duration, most are between 3-5 years; these loans offer less liquidity with regard to trading loans between lenders, but illiquidity premiums, such as higher interest rates, provide incentives for lenders to offer these loans.
Interest rates associated with these loans are floating rates above a standard reference rate and borrowers are typically limited in their ability to reduce the value of the loan.
A variety of loans are offered via direct lending agencies. Situational lending for companies with high revenue but no earnings, stressed sector lending for companies affected by situational market downturns, or sponsor financing for limited buyouts are all examples of loans that are typically offered through direct lenders.
Peer-to-peer lending, utilizing secured and unsecured loans, offers another platform for lenders and borrowers to access non-traditional revenue streams. Direct lending provides a variety of means by which individual to midsize corporate ventures can access the funding they need for financial stability and growth.
5 Advantages of direct lending
Direct lending offers a variety of improvements over traditional bank-based loan funding:
- 1. For secured loans, direct lending loans typically have higher seniority, which means that they will be paid out in the event of default. This is an obvious benefit to the lender that at least guarantees some collateral in the event that the entity receiving the loan does not generate a sufficient return on investment.
- 2. Direct lending typically generates higher interest rates for lenders with less volatility given that it is not subjected to market pressures as are other publicly traded securities and capital management strategies.
- 3. For midsize companies, the loan acquisition process is much more flexible with regard to capital evaluation, the duration of the loan as well as interest rates for the loan. Further, direct lenders don’t offer to require large down payments for the loan, as many banks do.
- 4. Direct lenders, unlike banks, own the assets they are lending, which eliminates dealing with third parties as well as the complicating steps to getting approved for a loan. Further, direct lenders don’t sell your financial information and therefore offer an additional level of privacy and security.
- 5. For borrowers, direct lending offers more guaranteed capital availability that ultimately has lower costs given the reduced administrative oversight with greater back-end accessibility given that the loan is maintained with the direct lender for the duration of its term. Some lenders may also offer loan consolidation or repayment options depending on other loans issued via the lender.
5 Disadvantages of direct lending
While direct lending offers many improvements over bank-issued loans, a variety of concerns still exist with regard to loans issued through direct lenders:
- 1. Direct lenders that pursue leverage through commercial lending institutions may face shorter leverage durations than the length of the loans issued, creating leverage disparities. Likewise, considerable due diligence is required to evaluate the viability of entities seeking direct loans, particularly businesses that have a disproportionate revenue-to-earnings ratio and more technical processes, such as life science operations.
- 2. From a lender perspective, there is a considerable amount of competition in the direct lending market, particularly given the shifts in lending preferences since 2010, making it more difficult to offer competitive rates.
- 3. For borrowers, direct lending loans can vary substantially between lenders, requiring sufficient due diligence as well as evaluations of the credibility of the lending agency.
- 4. Although lenders may not require down payments, interest rates can be higher and repayment rates may be more frequent than with traditional loans.
- 5. With peer-to-peer direct lending, there is no guarantee for the lender to secure the loan, if it’s an unsecured loan, which could lead to financial loss, and the loan is typically tied up with the borrower until repaid. Borrowers face potentially higher interest rates, given the volatility of the loan, and may have to pay additional fees to secure the loan.
Although direct lending has its drawbacks, for small, start-up or credit-strapped operations or individuals who aren’t able to secure loans elsewhere, direct lending can be a lifeline that can help to keep operations going.
For those interested in venturing into the world of direct lending or who need to secure alternative financing, considering the above advantages and disadvantages can help you decide how to incorporate direct lending into your capital management strategy.