Oaktree Capital is monitoring “potential pockets of weakness” in direct lending, some of which create opportunities for portfolio trading, but said it does not believe the asset class is “broken”.
Speaking on a recent episode of the Oaktree Capital podcast Understanding: ConversationsBrook Hinchman, head of North America, global opportunities, identified three problems “coming to the surface” at the same time.
“The first is that about a quarter of the direct lending market has asset credit where these short-term funds and private business development companies (BDCs) have quarterly redemption features in what is an illiquid asset class,” Hinchman said.
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He said the second is a “classic problem” because the 2021 and 2022 leveraged buyouts (LBOs) are “overbooked”. “These LBOs were made under the assumption that interest rates would be zero going forward,” Hinchman explained.
He also pointed to business software as a third issue, given that “it was the most exposed sector and it was the sector with the highest leverage, and the highest ratings”.
The threat posed by AI to the business software sector, particularly Anthropic’s Claude Code, has been in the headlines recently, with concerns about the sector’s private liability exposure.
“The main barrier to entry for enterprise software was the ability, one, to develop code, and two, to change your data, and to change your processes and systems from one enterprise software to another. Those barriers to entry have come down meaningfully and caused a wide dispersal between the winners and losers of a category of business models that, historically, have been strong and stable, explained Hinchman at length.
He added that, while the company doesn’t think direct lending as an asset class is broken, what they do see is “that current deals are overexposed to one challenging industry and overexposed to one bad maturity” of LBOs.
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Harry Whitelaw, vice president of Oaktree’s marketing and communications team, said: “I don’t think we believe the property division is wrong. In fact, the idea of private lending that has been discussed in PE-backed companies makes a lot of sense.”
Whitelaw asked Hinchman and Matt Wilson, portfolio manager, special situations at Oaktree Capital, if they saw “a lot happening in the direct lending market”, such as limited partners or general partners trying to release loans.
“What you don’t have in the direct lending market, because it hasn’t evolved yet, is a real exchange like what you have on a trading desk in the integrated market. What you’re seeing now is a portfolio exchange,” explained Wilson, who said. he added that “the blurring of information is part of the problem there”.
However, Hinchman said that they see opportunities in direct lending portfolios that “because of the asset credit mismatch and because of the redemptions by investors to meet that amount, we are starting to see the portfolio trade”, and that they expect these opportunities to “accelerate”.
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