European debt: Opportunity beckons as banks retrench

    Record deal levels in Europe point to a market that is rising to the macroeconomic challenges.

    Despite unprecedented macroeconomic uncertainty, private credit funds in Europe enjoyed the busiest Q2 on record this year as they executed 216 deals, compared with 154 in the same period of 2021.

    This 40 percent increase, recorded in Deloitte’s Alternative Lender Deal Tracker, is matched by a 16 percent increase in the half-year tally, as alternative lenders stepped into the gap left by banks and public markets and took on bigger and bigger deals.

    “The private debt market has picked up transactions that would probably have been done in the public markets under normal circumstances,” says Robert Connold, partner in debt and capital advisory at Deloitte.

    While leveraged buyouts remain the key drivers of private credit activity, accounting for 48 percent of European deals in Q2, refinancings are on the increase. Connold says: “We have seen an uptick in refinancings, which weren’t happening two years ago during lockdown when a lot of debt funded transactions were either M&A or bolt-ons. People have pushed those facilities out because they were happy to stay put, but now those deals need to be refinanced.”

    Connold highlights the largest-ever private debt financing in Europe in June by The Access Group, a leading software provider. Undertaken by a large group of lenders, the refinancing continued a trend that has been gathering pace over the past few years and has only been accelerated by dislocation in the public markets this year, he says.

    Market share growth

    The market volatility fuelled by rising interest rates, burgeoning inflation, supply-chain issues, energy cost hikes and conflict in Ukraine has also served to drive banks out of European lending. Mark Brenke, head of Ardian Private Debt, says: “Activity across our core markets in Europe – France, Germany, the UK, Benelux, Scandinavia and increasingly southern Europe – has been very strong in H1. We have seen deals being driven by an acceleration of bank retrenchment over the last 18 months.

    “This acceleration has been most pronounced since the covid-19 pandemic and amid the current market volatility,” says Brenke. “Our view is that ongoing bank retrenchment will only drive more opportunities for direct lenders in the coming months.”

    “The European private credit market is still viewed as underdeveloped”

    Jeffrey Griffiths
    Campbell Lutyens

    The absence of bank competition across Europe has led debt funds to swallow up market share, with investors attracted to the private credit asset class as a result.

    Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens, says: “The European private credit market is still viewed as underdeveloped, with more growth potential and some attributes that make it more attractive than the US to investors.”

    European deals are still slightly more bank-like in their documentation, with more creditor protections, which are important in this type of climate, he says.

    “In Europe, you tend to see less of a syndication model and more managers doing deals where they are taking down the whole thing rather than sharing with others,” says Griffiths. “In the US, it is much more common to have clubs of two or three players, and what that means is that in Europe the lender generally has a bit more power when it comes to documenting terms and it is more of a winner-takes-all market.”

    Griffiths notes that investors are much more cautious on Europe right now, given the macroeconomic outlook being compounded by concerns over energy security, but he says fundraising is still getting done for the right managers.

    Ardian’s Brenke says there have been a number of new entrants to the market in recent months, “particularly traditional asset managers looking to diversify into direct lending”.

    In contrast, there have been few new private debt funds emerging, he says. “Ultimately, investors are focused on managers that can present a strong track record, especially during volatile periods like the pandemic. Those without historic returns to point towards will find it challenging to attract capital.

    “It is also difficult for new lenders to differentiate themselves, both for investors and sponsors. On the flip side, market incumbents who have performed well are set to benefit from this period of dislocation as investors place their money with funds they can trust.”

    Diversification play

    At London-based Sona Asset Management, which specialises in investing across the credit spectrum, CIO John Aylward says: “We find there are pockets of the markets where capital remains scarce due to factors such as complexity – and, consequently, premiums can remain high. These less-competed pockets are often only available to more flexible investors who can solve this complexity with bespoke solutions, creating value. The majority of capital in private credit remains constrained in strict lanes – once you step outside these lanes, premiums can move up aggressively.

    “We find there is also benefit of being a resident, not a tourist – satellite teams from US firms, who do not have as long a history of investing in Europe, may struggle to understand the multiple ways that idiosyncratic credit stories can unfold with the equivalent speed of European experts.”

    The Deloitte data shows that half of all the private debt deals done in Europe in the second quarter of 2022 were unitranche deals, with a further 30 percent being senior loans. PIK deals, mezzanine and stretched senior transactions accounted for 7, 4 and 4 percent of activity respectively, as managers saw an opportunity in more opportunistic strategies.

    Eric Capp, partner and head of origination and co-head of direct lending at fund manager Pemberton, says: “Pemberton’s Strategic Credit Fund is finding opportunities to support incomplete syndications and provide financing solutions to high-quality companies and our banking partners where the syndicated market is not open.

    “We’re also seeing an uptick in proprietary transactions, where private equity sponsors have acquired in secondary buyouts Pemberton portfolio companies. In these transactions, Pemberton has provided the new LBO financing on a proprietary basis.”

    Another developing opportunity, he says, is the growing demand for complex first lien financings; “These are often bespoke transactions where the sponsors are merging multiple founder companies in buy-and-builds and require the flexibility offered by our strategic credit funds.”

    Amyn Pesnani, who heads up Triton Debt Opportunities, the debt arm of European mid-market investment firm Triton Partners, tells a similar story: “As an opportunistic investor, the current freeze in the overall European syndicated and loan markets has created a range of exciting pull-to-par opportunities for us. Mid-market borrowers are struggling to secure financing, so we can step in via opportunistic primaries in addition to secondary markets.”

    The second quarter of 2022 was Triton Debt Opportunities’ most active period of capital deployment ever, he says. “Our deal pipeline is strong. Continued market dislocation and stressed balance sheets will only increase the pool of fundamentally sound mid-market businesses experiencing issues.”

    Private credit assets tend to benefit from seniority, strong covenant protections, solid equity cushions and the backing of long-term investors, so are well-positioned to weather a recession.

    That means that while there are choppy waters ahead for Europe’s debt funds, at the end of H1 2022 the story remains one of opportunity just as much as challenge.

    Real estate: ‘It’s a great time to be deploying capital’

    The impact that the looming recession might have on portfolios is front of mind.

    However, the shift in the cost of capital creates opportunities, according to Natalie Howard, Schroders Capital’s head of real estate debt.

    “There are definitely challenges in legacy real estate debt portfolios,” says Howard. “Certain sectors have structural challenges, albeit there can be opportunities here to cherry pick opportunities that others may pass over. At the same time there are the sectors which have been the darlings of the last cycle, and which have been acquired on stretch valuations. The fundamental shift in the cost of capital will challenge many of these business plans. It’s a great time to be deploying capital rather than managing a legacy portfolio.”

    She points out that the macro shifts will nevertheless tend to favour private credit: “Banks continue to retrench from the real estate lending markets. Significant market events, such as the global financial crisis and covid, have each marked a step-change in the availability of bank capital. We see this change as structural and exacerbated by each new challenge. The higher rate environment is likely to prove to be the next.”