This article is sponsored by Bridgepoint Credit.
How would you describe the current state of the mid-market direct lending market in Europe? What was 2021 like, and how has 2022 started?
We’ve seen a significant amount of uncertainty over the last three years, with Brexit, covid and the unfolding situation in Ukraine. Inevitably that uncertainty brought challenges at a moment when we were witnessing an increasing penetration of the direct lending product across Europe.
Bridgepoint Credit had already accelerated the build-out of our teams in local markets across Europe to capture the additional dealflow. At the start of covid, there was a temporary negative impact on M&A activity across the region but thanks to our unique local footprint we were first out of the gates when markets unlocked at different times.
During 2021, we continued to go about direct lending with a mindset of healthy paranoia that a downturn could happen during the lifetime of any loan. When we are holding a loan for three years, we expect a downturn, and that never really materialised from an economic perspective.
This approach served us well through covid. Our portfolio performance proved stable and robust, particularly as less than 10 percent of our portfolio was in industrial assets or discretionary consumer assets. Covid was a test for portfolios but not an examination, because it was not necessarily an economic downturn. However, a downturn may not be far away.
Last year was incredibly busy as a result of pent-up demand from the sponsor community. We saw a number of high-quality deals, with businesses being bought and sold that proved their resilience through the pandemic. We have been investing in sectors like healthcare and technology-enabled services since our first direct lending fund, positioning us well to source and make investments in these spaces and accurately assess diligence risks, helping us avoid losses.
This year has started well with activity volumes remaining high. Today, we have a strong pipeline of deals close to being signed, but are conscious of the uncertain geopolitical environment in which we operate.
What do you expect to be the hot sectors for activity this year, and why?
We expect to see more of the same in terms of sector activity. Some 85 percent of all our investments in direct lending since inception have been in digital media and technology, healthcare and services – sectors we believe to be more resilient.
At the start of this year, I forecast greater pick-up in activity by our competitors opting to invest in industrial assets as covid moved into the rear-view mirror. But in light of the current situation in Ukraine, it is now going to be increasingly hard to gain conviction on industrial assets when you consider challenges around input costs and wage inflation.
Covid will change some aspects of consumer behaviour forever – this could make for some strong equity investments, if you can back the right trend, but for debt it just means that the past is no longer such a good predictor of the future.
We will see more of the same focus on more resilient sectors, and that means it will be particularly competitive for direct lenders in those sectors. Asset quality should remain high, with companies that have proven resilience through covid attracting ever greater demand.
What variations are you seeing across the European landscape? Which jurisdictions are seeing the greatest demand for direct lending, and why?
The pan-European outlook literally varies month by month. We have two pipeline sessions each week to screen new introductions with our colleagues in the UK, Stockholm, France, Germany and Amsterdam. It may be that one week there is an incredible amount of activity in France and then the next week it is all about the UK, or vice versa, but it always evens itself out over a fund cycle to allow us to build the right level of diversification.
We are also in the latter stages of building out our coverage of the Spanish market. The five markets we are currently in across Europe are home to more than 80 percent of European direct lending transactions, so we see Madrid as an opportunity to invest ahead of time. This is a market that is reasonably active right now but will continue to be more active going forward. We have already originated some transactions in Spain without a local presence and now we are looking to increase dealflow by replicating the approach that has worked for us in Benelux and the Nordics.
What is important, irrespective of jurisdiction, is consistency and deliverability. All members of our investment committee participate in screening every deal, which is important in increasing the likelihood of deliverability of investment decisions.
There is no doubt that the direct lending product is gaining market share across Europe. When we see volatile markets as we are today, and instability in capital markets, that allows direct lenders to take additional market share. Our fund structures allow us to take a longer view and when banks are nervous about underwriting loans, we can step in. Volatility promotes the stability of direct lending for our clients and so we expect dealflow to remain strong across Europe.
What will be the biggest challenges facing lenders like Bridgepoint Credit in Europe this year?
The macroeconomic environment is certainly more challenging than it has been for a while, so lenders should be focused on existing portfolios. Several of those investments were made three years ago, pre-Brexit and pre-covid, and now they are facing a high inflation environment, which is not likely to change in the near term.
In covid, we saw our portfolio performance remain remarkably stable, without the need for adjustments or government support packages. Other sectors were hard hit through no fault of their own, like consumer, but were able to rebound relatively quickly. Now those businesses are facing a tougher environment that may be more enduring, so as an asset class the challenge for direct lenders will be in monitoring portfolios well and taking action to navigate challenges, when required.
The biggest issue we are seeing in our portfolio is around labour costs. In the sectors we are in, like healthcare, services and technology, we have relatively little exposure to raw material costs or energy prices, but it is hard to be immune from wage inflation. For companies to stay competitive, they need to attract and retain talent. Many of our businesses are seeing labour cost inflation, but lots have contracted customers and are therefore able to pass through those costs.
We do not see any discernible differences between our European markets when it comes to the scale of those cost pressures on companies. There will be local variations, but it is a Europe-wide issue. We believe that being a senior secured lender is a good place to be in the capital structure. Last year, the loan-to-value of all our investments was 36 percent, so there is a lot of inbuilt buffer before that debt comes under pressure.
Furthermore, across our portfolio the average EBITDA margin of our companies is 31 percent, so these are businesses that add real value to their customers, even if they are not sole suppliers.
The key to withstanding cost inflation lies in the importance of the company to its customers. In healthcare, for example, if an end customer has to change supplier they have to get that new supplier certified, so they are unlikely to start that process and more likely to withstand a price increase from an existing supplier. The same is true in education, where a provider that already has a large number of children enrolled is unlikely to lose those students to another provider if they have to put the prices up in order to pay their teachers more.
What kind of opportunities does the current macroeconomic environment create for private credit?
We think 2022 will see continued high-quality deal activity in the more resilient sectors of the economy, and those businesses will absolutely remain attractive to sponsors. To the extent that there is any M&A reduction, we will see an increased level of refinancing in the private markets. Capital markets’ volatility in the syndicated loan market will mean more transactions being completed purely with private credit, so direct lending will continue to take market share.
We expect some markets to be quieter than others but broadly we feel that if portfolios remain in good shape, then lenders will be able to source new deals and continue deploying investor capital.
The market will remain intensely competitive for mid-market direct lenders, but there has been a maturing of the market in recent years and sponsors now have lenders that they favour and are familiar with working with. About 80 percent of our dealflow is with sponsors we have worked with in the past, so we believe the strength of those sourcing relationships will continue to bring us stellar deal introductions this year.