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In the wake of coronavirus, the 'club' loan returns as hold sizes in private debt shrink

The head of Morgan Stanley's direct lending strategy says a new age of "club" lending could be emerging, as private debt providers choose to hold smaller amounts of financing to a single borrower.

"Hold sizes across private credit providers have shrunk. There's less financing available now than pre-COVID. It's very hard to predict when larger hold sizes come back, but it could be a while," said Jeff Levin, head of Direct Lending at Morgan Stanley Investment Management.

Prior to the COVID-19 pandemic, plenty of private credit providers were willing to step up for loans of $300 million or more. Lenders held them on their books, distributing them across business development corporations, private credit funds and separately managed accounts. Now, many lenders are reserving capital for existing portfolio companies, versus deploying capital to new investments. In addition, risk aversion has increased, leading to smaller hold sizes and to sharing risk across what's known in the credit world as a club of three, four, or five lenders, Levin said.

"I think the club market will come back. Our private credit business leads deals, but will also play in that club market," Levin said.

Levin rejoined Morgan Stanley in February 2019 from Carlyle Group Inc.'s BDC, where he was president and part of the investment committee. He joined Carlyle in 2012 from Morgan Stanley, where he helped found the bank's private credit business.

Since rejoining, Levin has helped build a team at Morgan Stanley to go after the heart of middle market lending, a lucrative business in the recent decade.

In April 2019, Orit Mizrachi joined Morgan Stanley Investment Management as executive director. She previously was at Carlyle, where she spent almost a decade. That same month, Morgan Stanley hired Jeff Day as a managing director, based in New York. Day was previously an originator at Madison Capital. Late last year, Kunal Soni joined Morgan Stanley's Los Angeles office as a managing director. Soni worked closely with Levin at Carlyle, where he led the direct lending effort for the Western region. Last month, the Morgan Stanley team added David Kulakofsky, also from Madison Capital. Kulakofsky also joined as managing director, based in Chicago.

SEC filings show the seasoned team is busy ramping up a new private BDC, which began operations in late 2019, targeting loans to middle market companies generating EBITDA of $15 million to $100 million. Investments will be first- and second-lien loans, mezzanine debt, unsecured debt, equity, and opportunistic asset purchases. Portfolio companies will predominantly be private equity–backed.

Besides middle market lending, other areas of focus for the Morgan Stanley Private Credit platform are opportunistic credit investing and growth credit for privately held small and midsized companies.

For the quarter ended March 31, investments in which Morgan Stanley Private Credit participated included SaaS-based enterprise software providers such as IQNavigator (Beeline), MRI Software, and second-lien debt to Quorum Business Solutions.

More recently, Morgan Stanley Private Credit was a joint lead arranger on a $50 million incremental first-lien term loan to support an acquisition for Electrical Source Holdings, a portfolio company of Greenbriar Equity Group LP and a specialty distributor of "need-it-now" power components.

Morgan Stanley Private Credit also participated in financing for a recapitalization of AIMS Companies by Sterling Investment Partners and management. AIMS Companies provides infrastructure inspection, maintenance, and support services to municipal, utility, industrial and energy end-markets.

Middle market lending has become increasingly crowded in recent years, attracting investors due to higher yields and stronger credit protections than syndicated leveraged loans.

The Morgan Stanley Direct Lending Fund has more than $1.3 billion of available capital, of which roughly $1 billion is available uncalled equity and $325 million is available financing, and has called 9.6% of its total committed equity capital, SEC filings show.

"The market dislocation is offering exceptional risk-adjusted returns. Vintage 2020–21 deals should be very good. Dry powder is key," Levin said.

Most of the platform's deal activity is add-on acquisitions at the moment. Over time, Levin expects refinancing deals to step up, but it may be some time before meaningful new leveraged buyout activity returns.

Levin said the broad Morgan Stanley Private Credit platform is evaluating risk-adjusted returns across industry sectors, including ones affected by the COVID-19 pandemic.

This story was written by Abby Latour, who covers private credit/direct lending for LCD.

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