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Financing solutions provided by direct lending GPs tend to deviate from a bank-style base loan. As a result, they can tap into additional return drivers.

 Capital structure: The more junior a loan is positioned in a company’s balance sheet, the greater the probability that its nominal amount is not covered entirely by the borrower’s enterprise value. Also, a lender taking on a second lien or junior position has less control over the recovery process. Therefore, a risk premium is attributed to the lender’s position in the capital structure.

 EBITDA: Direct lenders consider a borrower’s EBITDA when estimating credit risk; a lower EBITDA typically equates to lower creditworthiness. Several factors can affect a company’s EBITDA, including market share, customer concentration, and cash flow stability.

 LTV: As with capital structure, the risk for the lender increases with the LTV ratio. Direct lenders seek greater compensation for loans that are less collateralized.

 Leverage: The more leverage a company uses, the lower its ability to service that debt. Not surprisingly, highly leveraged transactions incur a premium. Conversely, our analysis shows that transactions using very little leverage also command a premium. In our experience, this situation tends to arise in lending to smaller companies with less solid credit metrics, as noted above, or to companies in cyclical sectors.

 Covenants: Direct lenders can often put in place covenants to fit each borrower’s risk profile. This flexibility comes at a cost: Fewer covenants can equate to an additional risk premium.

 Sponsor/non-sponsor: Lenders often require a risk premium for lending to non-sponsor companies. Sponsor-backed companies typically have better financial reporting and corporate governance, as well as stronger management teams. Sponsors’ rigorous due diligence process provides lenders with additional confidence in the company’s business plan and ability to service debt. Lending to non-sponsor companies typically requires more time and effort in due diligence. Consequently, lenders often seek an additional compensation premium for their work.

 Strategy: Lenders specialising in complex situations also command a risk premium for their deeper sector expertise or the additional work needed to complete the transaction. They also have more freedom to charge a “scarcity premium” given the lower number of financing options available to borrowers in these situations.