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Cliffwater identifies European direct lending risks

The region’s market share will continue to grow, but currency concerns are among the red flags that investors should consider, says a new report.

Direct lending has made significant strides in recent years, particularly in the US, as firms have taken a significant share of the mid-market leveraged finance market away from commercial banks.

Having developed faster, the US direct lending market leads Europe in terms of sophistication, depth and the experience of market participants. However, the number of European debt managers has grown rapidly and deal pricing and structures are now broadly similar across the two markets.

In light of Europe’s emergence, US investment advisory firm Cliffwater has produced a report entitled “European Middle Market Direct Lending” to act as a form of guidance for US investors considering a potential European allocation. The report identifies three key risks:

1. The possibility of adverse currency movements eating into euro- or sterling-based interest streams. Through private equity allocations, US investors often assume the currency exposure of European investments, believing the long life and high expected returns of private equity will more than offset the impact of currency movements.

Direct lenders, on the other hand, are involved in short duration, stable income investment – meaning that currency movements can be more problematic. Some European direct lenders have put in place currency hedging for US investors, which may help alleviate currency exposure but adds complexity.

2. The lack of experience of some European direct lenders. Most of the market leaders in the US began their careers/firms before the global financial crisis and have experienced at least one severe credit downturn. Some European lenders have been around for a much shorter period of time. Given that credit conditions have been very benign for the last six years, it remains to be seen how these relative newcomers will perform during the next down cycle.

3. The prevalence of country risk. The European market is fragmented with direct lenders often focusing on specific countries – unsurprisingly, this is often their home markets – based on local familiarity with commercial norms and the legal framework covering creditors’ rights and insolvency. This home market bias means there is a large number of country-specific direct lenders in Europe whose portfolios are exposed to the vagaries of that country’s economic and political developments.

Cliffwater says US investors seeking diversification for their direct lending portfolios should be aware of these issues. However, it acknowledges that “the European market continues to develop” and “an allocation to European managers may become increasingly compelling”.

Comparison of the European and US direct lending markets: 

  Europe United States
Size of the corporate lending market (1) $2.0trn $8.5trn
Estimated number of alternative lenders (2)  Approx. 50 managers Approx. 150 managers 
Estimated size of private debt market (2) $170bn  $400bn 
Fund leverage (2) European investors prefer 
unlevered; managers offer
dollar levered sleeves with
leverage typically up to 1.0
times investor commitments
Most managers offer unlevered
and levered vehicles with 
leverage of 1.0 to 2.5 times 
investor commitments 
Interest rates (3)  Typically LIBOR/EURIBOR
+625 bps to LIBOR/EURIBOR
+800 bps for unitranche loans; 
upfront fees/OID of 1% to 4%
Typically LIBOR +600bps to
LIBOR +750 for unitranche
loans; upfront fees/OID of 0.5%
to 2% 
Average middle market leverage (4) 5.2 times debt to EBITDA 5.5 times debt to EBITDA

1. Securities Industry and Financial Markets Association, 2016 
2. Cliffwater Research. European private debt market share based on Prequin private debt dry powder and Cliffwater US estimate 
3. Based on Cliffwater Research: indicative pricing in the current market as described by managers 
4. S&P LCD Europe and US LBO Review Q1 2017