The $6.6 billion buyout of Stamps.com Inc. last year marked the emergence of private credit funds as a significant player in large public company LBOs. Thoma Bravo LP bypassed the bank syndicated lending market and instead got debt financing for the acquisition from Blackstone Inc. (BX), Ares Management Corp. (ARES), PSP Investments Credit II USA LLC and Thoma Bravo’s own credit fund.

The private equity sponsor has turned to private credit funds on a number of other large deals since Stamps, including the acquisition of Medallia Inc. for $6.4 billion and the pending $10.7 billion buyout of Anaplan Inc. (PLAN). Permira Advisors LLC funded its $5.8 billion purchase of Mimecast Ltd. the same way.

Direct lending, as the financing that private credit funds provide for buyouts is called, developed in the middle market, which it now dominates. As direct lenders have raised larger funds, they have taken business from banks on multibillion-dollar buyouts, especially in technology and healthcare. Private equity sponsors have become adept at pitting direct lenders and banks against one another in competing for deals, which has led to significant convergence of terms in the two markets, though direct lenders have been able to retain some creditor protections that banks generally are not able to get.

Banks have had to respond to competition from the direct lenders, though some of the advantages the latter group has are difficult for commercial banks to match. That raises the prospect that direct lenders could become more important providers of debt financing in the years to come — which could attract more regulatory attention to the direct lending market if there’s the perception that it increases systemic risk, especially as direct lenders raise money from retail investors.

The direct lending market grew out of the term B loan market that emerged in the 1990s, fueled in part by the emergence of collateralized loan obligations, or CLOs, said Patrick Ryan, the head of the global banking and credit practice at Simpson Thacher & Bartlett LLP. A traditional bank loan generally has meaningful amortization over its term. On a term B loan, the lender pays almost the entire principal back at the end of the loan, which generally has a life of five to seven years.

Term B loans generally carry a somewhat higher interest rate than bank debt and appeal to investors willing to trade amortization and certain terms for a higher return. Private credit funds developed along with the term B market, and private equity sponsors saw an opportunity to expand into that market, Ryan said.

Private credit funds invest in several types of debt, including mezzanine, distressed, special situations and venture debt, but direct lending to healthy operating companies has come to account for the largest share of the private credit market. Banks are also increasingly focused on opportunities in the private credit market and have begun to allocate capital to fund loans in the area.

After the great financial crisis in 2008, the Office of the Comptroller of the Currency issued guidelines suggesting that commercial banks limit the leverage on the loans they made to six times earnings. As a result of those guidelines and a desire to reduce credit risk, banks scaled back on lending to middle-market companies.

Private credit funds, which are not subject to OCC oversight and thus didn’t feel constrained by the guidelines, stepped in to fill the void, and private equity sponsors increasingly turned to them for debt financing on middle-market deals, which are too small to be sold in the CLO market. According to a recent report from consulting firm McKinsey & Co., banks now account for only 11% of those financings, down from nearly 70% in 2013.

As the banks receded from the market, institutional investors looking for higher yields in a time of low interest rates increased their allocations to private credit funds, which were able to put the money to work because of the expansion of private equity activity. As the McKinsey report noted, buyout volume has risen almost threefold over the past decade.

With ever-increasing amounts of money to invest, credit funds have sought out larger deals. In 2016, Thoma Bravo paid $3 billion for Qlik Technologies Inc. and funded the buyout in part with a $1.08 billion unitranche facility led by Ares Capital Corp. (ARCC). Originally a product aimed at the middle market, a unitranche is a single class of debt that offers borrowers an easier, quicker approval process than financing that includes second-lien or mezzanine debt in addition to first-lien debt. That evolution has continued with deals such as Stamps.com, which was also done as a unitranche.

Direct lenders have done particularly well in sectors such as technology and healthcare where private equity firms have become much more active over the past decade. Said Kenneth E. Young, the co-head of private equity at Dechert LLP, “In industries with lots of change, new entrants may not have strong banking relationships, and once the playing field gets flat, if the originators of the private credit get to the sponsor first, then they have a good shot to win the business.”

As the direct lending market has grown, the product has remained different from bank syndicated loans in several respects. Credit funds make loans with the expectation that they will hold them for their entire term, generally five to seven years. The credit funds do significant due diligence on the borrower and are generally able to act more quickly than banks can.

Credit funds have also prospered in part by being able to offer unitranche financing. According to a recent report from Churchill Asset Management, 77% of unitranche deals are now worth more than $250 million, compared with 28% in 2017, though unitranche activity by dollar volume is about a quarter of that in the syndicated market.

Banks negotiate for flexibility in key terms such as interest rate on debt they intend to syndicate — what’s known as flex in the lending world. In contrast, credit funds are able to make firm commitments on terms to lenders, and because the debt isn’t syndicated, direct lending allows borrowers to limit disclosure of commercially sensitive information. Credit funds also aren’t affected by sudden tightening in the syndicated loan market. In exchange for these advantages, borrowers pay higher interest rates, which are generally floating as opposed to the fixed rates banks offer.

Credit funds have also adjusted their orientation to the market. Matthew Einbinder, a finance partner at Simpson Thacher in Houston, said: “Some borrowers focus on issues of future control when looking at the differences between banks and private lenders. But private lenders are also prioritizing the development of lending relationships and often emphasize issues such as pricing, willingness to extend capital, confidentiality and other primary commercial terms.”

But to compete with banks for large deals, direct lenders have had to offer interest rates and terms that are highly competitive with those on syndicated bank debt. Private equity sponsors increasingly run dual-track processes in which they pit direct lenders and banks against one another.

“It’s not uncommon for sponsors to look to the two financing sources on a single deal for different parts of the transaction,” said Daniel Seale, global chair of the banking practice at Latham & Watkins LLP. “There are deals with underwritten financing where a direct lender may take a piece of the underwritten deal. There are also deals with a syndicated first lien and a privately placed second lien or even a preferred tranche.”

As a result of the competition, “there has been a convergence between private credit and syndicated debt terms, including ‘covenant-lite’ terms on private credit deals, even since the first large direct lending deals were announced,” said Eric Wedel, a finance partner at Kirkland & Ellis LLP. “This is because private credit providers are competing for deals that would otherwise go to the syndicated markers and because there are a larger number of lenders participating in the deals.”

Direct lenders are also able to offer products that banks can’t, such as delayed-draw term loans, which allow borrowers to draw down money over time and are helpful for sponsors that want to make bolt-on acquisitions to a platform investment. Delayed-draw term loans are committed facilities, generally with amortization that matches the initial term loans on a deal. They differ from typical revolving loans in that once the borrower repays the delayed draw loan it cannot again borrow on that loan.

Scott Selinger, a finance partner at Debevoise & Plimpton LLP, added that direct lenders focus on ensuring that financing documents include provisions to help prevent outcomes like those in the J. Crew, Chewy and Serta deals. These protections aim to ensure that assets and even entire entities are not moved out of the credit group, as occurred in the J. Crew and Chewy transactions, and that the agreements do not permit non-pro rata priming transactions, which result in existing nonparticipating lenders being subordinated to a new class of senior debt, as happened in Serta.

There are other areas in which banks’ syndicated loans are more borrower-friendly than loans provided by direct lenders. Ryan Rafferty, another finance partner at Debevoise, cited Ebitda add-backs and most-favored-nation (MFN) — a term borrowed from international trade — protections as two such areas. In unitranche financings, Ebitda add-backs are typically less flexible than those in syndicated financings.

MFN pricing protection reprices the borrower’s existing financing if a subsequent debt issuance has a higher all-in yield to ensure that the all-in yield on the existing financing is within a predetermined cushion compared with the new financing — typically 50 to 100 basis points. MFN protection is also typically subject to fewer if any exceptions for unitranche compared with syndicated financings.

Direct lenders are likely to become even more competitive in funding large buyouts because of the amount of money they are raising. “The size of BCred was a wake-up call to the managers that private credit could be bigger,” Dechert’s Young said, referring to Blackstone Private Credit Fund, a business development corporation launched last year by Blackstone that has already raised over $30 billion in assets. “The biggest changes over the last three to five years have been the inflow of foreign capital and the increased number of ways for retail investors to access private credit.”

According to a recent Prequin report, 2021 was the seventh consecutive year of record fundraising for the private credit market, and the first quarter of this year suggests the trend will continue. And as the McKinsey report notes, figures on money raised by private credit funds do not include the capital in business development corporations or money managed as part of insurance capital pools.

Blackstone has been successful in part by raising money from high-net-worth individuals, and, Wedel said, the retail channel “is the lodestar for how to organically grow the amount of capital that funds are putting to work.” Demand from wealthy investors for credit funds has resulted in M&A. Last year, for example, T. Rowe Price Group Inc. (TROW) paid $4.2 billion for alternative credit manager Oak Hill Advisors LP, a deal where Young advised T. Rowe. And alternative asset management firm Owl Rock Capital Group merged last year with Dyal Capital Partners, a division of Neuberger Berman Group LLC, to form Blue Owl Capital Inc. (OWL).

Banks have an advantage in winning industrial buyouts, the traditional focus of PE sponsors, and remain stronger on international deals, in part because credit funds raise most of their money in the U.S. “Direct lending remains less common on large cross-border deals,” Seale said, “particularly given the fragmented European regulatory landscape, but its penetration of the market continues to expand, and that trend will likely continue.”

Banks have also responded to the rise of the credit funds. They’ve tried to become more competitive on terms and pricing, and some of the large commercial banks are launching their own credit funds that will be free of at least some of the regulatory restrictions on the syndicated lending market. But credit funds have evolved significantly from their roots in middle-market lending, and they seem poised to take an even larger share of big-ticket LBO activity, especially as sponsors become more active in tech and healthcare.