BlackRock asks whether private debt is in transition

The European private debt market is becoming increasingly established and mainstream. So, what shape will this more mature market take and what are the trends to watch over the medium term?

This article is sponsored by BlackRock

Stephan Caron

The private debt market has grown rapidly in recent years, with investors increasingly allocating to private debt strategies in a bid to generate returns in a persistently low yield environment. Yet, as signs emerge of an economic slowdown, can private debt funds continue to expand at the same rate? How will this affect lending conditions? And, following particularly robust growth in Europe, how will the industry settle and mature over the coming years? These are some of the issues we discussed with BlackRock managing director and head of European mid-market private debt, Stephan Caron.

European mid-market direct lending has expanded rapidly. What would you say are the most important recent developments?

The market has certainly grown significantly. According to Deloitte, the annual growth rate was around 30 percent for the past five years. One of the biggest developments has been the emergence of a more pan-European opportunity set. While much of the initial growth was particularly UK-focused, we are now seeing healthy growth across Europe.

Our experience is reflected in Deloitte’s data, showing that the UK still accounts for around 40 percent of European private debt transactions; France now accounts for 25 percent and Germany 11 percent. Germany is one of the fastest-growing markets in Europe and so it is likely to have a much greater share over the next few years.

A recent report by GCA Altium showed that 50 percent of mid-market buyouts in Germany were financed with private debt – that’s up from just 16 percent in 2016, so it’s quite a shift. We’re also seeing growth in Benelux, Spain and Italy and early signs of development in the Nordics too.

This is good news for investors, many of whom were concerned that their allocations were too heavily concentrated in the UK, where there are attractive opportunities but also a high degree of uncertainty. Our direct lending strategy has approximately 20 percent exposure to the UK, which is relatively low for a pan-European strategy, but aligns with our investors’ conservative view on the UK and their desire for a high degree of geographical diversification. We have been able to meet those goals thanks to our strong local presence in European markets.

What developments would you like to see?

Back in 2011 and 2012, when the asset class really started gaining traction in Europe, there were high expectations that sponsorless transactions would be the main driver of growth. In fact, the market has remained largely sponsor-driven.

That said, we think the direction of travel is still towards convergence with the US in terms of dealflow and financing dynamics, but given we currently have roughly an 80-20 split of sponsored/sponsorless transactions in Europe, compared to 50-50 in the US, it may take longer than expected to materialise. That’s largely because many companies are not yet familiar with direct lending institutions or how private debt can work for them as an alternative to bank financing.

A very long-term – and I should stress aspirational – development would be some harmonisation in the regulation and insolvency regimes across the EU. Currently, you have to have different vehicles and/or licences in different member states to provide loans in Europe, as well as a lot of experience in structuring deals in different legal and regulatory frameworks. With local offices across Europe, we can handle that lack of harmonisation but to an extent it restricts competition. It’s a similar story with insolvency regimes – it would be great if Europe could have, as an aspirational goal, a single regime across the EU.

“Many companies are not yet familiar with direct lending institutions or how private debt can work for them”

How is the industry evolving?

Over the past few years, we’ve seen greater segmentation of the market – a natural consequence, we believe, of a market that is becoming more established. Previously, private debt funds tended to be chasing the same deals. Now, we find that domestic funds are financing smaller company deals, say in the less than €10 million EBITDA range, while the large players with €4 billion-plus funds target companies with €50-100 million-plus EBITDA.

Yet in the core mid-market space, there is less competition from funds and the opportunities are too small for the high yield bond or syndicated loan markets. Commercial banks are active but tend to use club deals, which aren’t the most efficient way of achieving financing as they take time to arrange and agree on terms. We also see that banks are rapidly scaling back their mid-market leveraged finance operations which tend to be less profitable and will come under more pressure with the new IFRS 9 rules. The lack of competition from banks in this part of the market is reflected in returns and means that the documentation standards agreed as a lender can be better – and that’s particularly important in this part of the cycle.

Where do you expect to see most growth for private debt?

We’re already seeing significant momentum in Germany and expect to see continued penetration of private debt in Spain and Italy, with banks in Spain in particular teaming up with funds. Growth in the Nordic region has been somewhat slower, but we expect this market will open up in the short to medium term. This region has a very vibrant private equity market, the companies there tend to be well managed, the insolvency regimes are robust and, as an investor, you can take comfort in the legal systems.

Further afield, the Asia-Pacific region is becoming increasingly attractive, especially as there is currently little competition – it’s difficult to establish in these markets because they are highly fragmented. India, for example, has a rapidly growing economy and recently saw insolvency law reforms which have helped increase recovery rates and speed up restructurings. We expect that to be a great opportunity for private debt players like BlackRock who have local capabilities in those countries.

Direct lending has become an increasingly important part of the US corporate lending landscape and the well-established direct lending market continues to expand, driven by demand from an increasingly broad array of borrowers for flexible and reliable financing provided by non-bank lenders. We’re witnessing growth in both sponsored and sponsorless opportunities in the US, across a range of industries. Providing capital to support the continued growth of technology companies, in particular, is an area of high growth for direct lenders. Successfully investing in these opportunities, however, requires deep insight and prior experience of investing in these types of companies.

So where would you say we are in the credit cycle?

There are some who question whether there is a cycle, but we believe there is one and we’re in the later stages. We recognise that a slowdown is occurring in the US, Europe and China, but that central banks are also being extremely accommodative – the Federal Reserve recently reduced interest rates and the European Central Bank is using unconventional measures to support the economy. Debt maturities have also been pushed out so that, even where companies are experiencing low EBITDA growth, they are still generating enough cash to service debt.

This lower-for-longer environment could continue for quite some time. However, it is important to recognise that geopolitical risk is high, with populism a global challenge. We observe various potential flashpoints from a US president facing an impeachment inquiry and upcoming elections, to US-China tensions and persistent instability in the Middle East. Closer to home, investors have to navigate the uncertainties surrounding Brexit and populist pressures across Europe. There’s clearly a lot of uncertainty and investors need to ensure they focus on constructing long-term allocations that can navigate these dynamics.

How can you mitigate this risk?

You have to build resilience across the portfolio and focus on downside management to counter uncertainty. At a high level, that means avoiding cyclical sectors and focusing on more defensive businesses. We see a lot of opportunity in areas such as healthcare, technology and food and beverage, which have historically outperformed in more difficult stages of the cycle.

Building resilience is also down to effective risk management and this is an area where we have invested significantly in sophisticated systems that allow us to stress-test individual investments, but also to track risk factors across all investments and identify correlations. This gives us a greater ability to assess the impact of macro developments on our portfolios on a daily level or more frequently if we need to.

Combining these tools with the insights from the BlackRock Investment Institute, our in-house think-tank, gives us an additional perspective on the opportunities and risks in our markets. We also have an independent risk team that is represented on our investment committee. They run their own risk dashboards and stress tests and have the experience and authority to challenge our investment teams on downside cases. And then, of course, we have to take a disciplined approach to documentation and not be afraid to walk away from a transaction if we don’t feel that there’s enough downside management.

How do you approach negotiating the legal terms? 

We look at deals where there is lower competition because, in our experience, in situations where you have 10-20 lenders vying for a deal, you may have to compromise on terms. To find lower competition deals, you have to have local origination capabilities, but you also have to be prepared to draw a line in the sand.

We sometimes encounter situations where the headroom is too wide and EBITDA adjustments too broad. Sponsors are pushing hard – I’ve seen an instance where a sponsor was requesting that foreign exchange be excluded from the EBITDA definition, yet that can have a significant effect on cashflow. You can’t be dogmatic about terms and can make an exception for outliers, for instance in counter-cyclical businesses where you’ve thoroughly analysed the opportunity, but generally you have to take a robust view of which terms you are prepared to accept and which you’re not.

What trends do you think we’ll see in the future?

We’re seeing a slowdown in new entrants to the market because barriers to entry have increased – you need scale now to invest in origination capability, IT systems, risk management, more specialised fund structures and so on. Moreover, we expect further consolidation and segmentation as the market becomes more mainstream.

How do you see investor allocations playing out?

Direct lending has enjoyed strong inflows over the past few years and investors are becoming increasingly selective in allocating to the space. The single biggest driver for investors to allocate to private debt has been low interest rates and that looks set to continue. As we speak, you have around$16 trillion in negative government bonds globally. Investors are switching away from fixed income, where they are struggling to generate returns, and into alternative strategies, including private debt. Earlier this year, the BlackRock Global Rebalancing Survey, which maps the asset allocation intentions of investors with a total AUM of around $2 trillion of assets, suggested that more than 50 percent of these intended to increase their allocation to private debt.

In our view, most investors are still under-allocated to the asset class. According to Preqin, the average allocation is around 5.7 percent of their AUM, so we exptect further increased allocations from a range of investor types. Insurance companies, for example, generally find private debt attractive from a Solvency II perspective. We’re also experiencing a significant uptick in interest from family offices and high-net-worth individuals.

As investors allocate more, they tend to have more precise demands on the industry. We’re seeing requests for funds of one and evergreen structures, for example, or multiple currency sleeves and levered and unlevered sleeves. We’ll see more innovation here as the industry seeks to structure funds to meet investors’ different needs.

Sustainability is an increasingly important factor in investors’ manager selection decisions. At a minimum, investors expect managers to have robust ESG policies in place and to ensure that these policies are integrated with their investment processes.

Sustainable, well-run businesses are inherently attractive to cashflow lenders. Direct lending offers significant opportunity to access such companies and achieve close alignment with investors’ evolving ESG goals.