The rise of the private debt funds to fill the void left by the postcrisis regulatory environment for banks has led to a changed landscape for company lending, in particular for private equity deal acquisition financing. With investors seeking yield in a prolonged low return, low interest rate setting, the private debt market has been on a roll over recent times, with players such as GSO, Oaktree and ICG raising multi-billion dollar funds in the last few years.
So where does this leave the banks? In the US, the answer is relatively straightforward: their leveraged lending share has shrunk to less than 20 percent since the crisis, with the funds picking up most of the slack. In Europe, however, banks remain in pole position, making up around 75 percent of the lending market, according to the European Banking Federation. “The European and US markets are very different,” says Justin Mallis, principal at First Avenue. “In Europe, banks continue to be a dominant force in lending; in the US, the capital markets and private debt fund landscape is much more developed. That means the competitive environment is very different. For example, the banks don’t compete in the smaller deals in the US.”
Playing funds at their own game?
Yet that doesn’t mean that European banks have been content to watch as alternative lenders take market share, even if the proportion is lower than in the US. Indeed, there have been whispers circulating around the market over the last year about a handful of banks looking to establish their own funds, a move that could place them in direct competition for deals with the private debt players. “Market rumours are that some banks have been considering establishing their own direct lending funds,” says Floris Hovingh, partner and head of alternative capital solutions at Deloitte. “It could be an interesting move as it would bring them into the asset management space rather than lending just from their balance sheet with the fee generation capacity that brings.”
“We have heard talk of some banks looking at the idea of establishing fund vehicles that invest alongside their balance sheet activities”
One of the most obvious areas for the banks to regain market share would be in refinancings – there will be a peak of European leveraged loans and high yield bonds maturing in 2020, totalling nearly $90 billion, according to Dealogic. “If the banks were to establish their own funds, refinancings would be an area where they could play an important role because there will be a significant need for additional capital,” says Monica Barton, partner at Reed Smith. “If they could work with higher leverage levels through funds, they would be interesting competition for the existing fund players.”
However, this would not be an easy ride for the banks. As Hovingh outlines, there are some hurdles they would need to clear. “It’s not a straightforward move,” he says. “They’d need skin in the game in these structures and they’d have to overcome fears that they’d end up competing with their existing bank lending business, but these are obstacles that could be surmounted.”
It would also require a change in mindset in what are often conservative institutions. “They would need to determine whether a fund raised on certain investment criteria would still need to go through a credit committee,” says Barton. “The question is whether the model would evolve into being a completely separate vehicle or a quasi-debt fund that would still rely on credit committee decisions.”
There are bigger potential barriers, too, as First Avenue partner Tavneet Bakshi outlines. “We have heard talk of some banks looking at the idea of establishing fund vehicles that invest alongside their balance sheet activities,” she says. “The issues they face, however, are around governance and alignment – a fund set up is very different from a bank credit/investment committee structure – and fees. On fees, the banks would find it challenging for the fees to flow through to the fund as opposed to going back to the bank. That could make it an unviable strategy for them.”
Or a meeting of minds?
Given these issues, and the fact that the market is now pretty crowded in Europe, it could be that banks have left it too late. “If banks had established funds five years ago it could have been a game-changer,” says Hovingh. “Banks do have one big advantage – their origination capability – but given that there are 70-plus direct lenders in Europe now, with some really big players, there would need to be a significant shift by the banks towards the fund model for this to have much impact.”
Instead, collaboration between banks and funds seems a more likely path – for now, at least. Banks, after all, continue to see more value in ancillary services than leveraged lending and therefore often view funds as a more attractive partner than another bank that would be competing to provide these more lucrative products.
For funds, there are also advantages of working with banks. “The story post-crisis was of bank disintermediation,” says Bakshi. “But over the last few years, many GPs are now open to the idea that, as banks are not going to exit the market completely, there is scope for collaboration through partnerships and preferred partner arrangements.
The banks have such huge origination and work-out capabilities, private debt funds have recognised there can be a lot to gain by working together – the trick for GPs is to ensure they retain an appropriate amount of control.”
And it’s a way of doing business that has evolved over recent times. “The ways in which funds and banks are collaborating has developed rapidly over the last few years, with a number of different models emerging,” says Hovingh. He points to formal partnerships, where banks originate and exclusively sell down to direct lenders on a pari passu basis, such as the arrangement between RBS and M&G, AIG and Hermes. There are also more informal arrangements developing in instances where, for example, banks take one turn of debt and offer the remaining turns to a debt fund. And then there are the formal JV structures, a recent example of which is the tie-up announced in March 2017 between Park Square Capital and SMBC to establish a €3bn European direct lending vehicle.
Over the longer term, it may be that European banks can find ways of addressing some of the issues with establishing their own funds, particularly once the uncertainty of Brexit has cleared – banks that had been exploring the idea of establishing funds have put plans on ice while arrangements are made for a post-Brexit Europe, according to Barton. Yet for now, it seems as though the market will be characterised by competition between the two forms of finance (particularly at the larger end of the deal spectrum where the large players have little need of bank assistance, given the large amounts of capital they have raised) and collaboration.
“There is a general acceptance in the market that banks and funds need each other,” says Barton. “The funds aren’t as good at originating as the banks and the companies they finance still need RCF facilities and term loans. The debt advisors will continue to play the two sides off each other, but there will always be a space where the two sides can work together.”