European direct lending could outstrip US – report

Direct lending in Europe has been driven by bank consolidation and is set to grow further following the covid-19 pandemic.

Europe’s direct lending market could become bigger than the US over the coming decade according to a report from Oxford University’s Saïd Business School commissioned by Pemberton.

The report said Europe currently trails the US in terms of direct lending AUM as a percentage of GDP but said there is significant room to catch up if European direct lenders can increase their AUM by a further 50 percent.

It added that: “Europe’s stricter regulatory environment, shrinking banking sector, lower yield environment relative to the US, as well as a large pool of private companies that may transition to PE in the next decade, all provide compelling reasons for direct lending in Europe to potentially take on a bigger market share than the US.”

The report notes that direct lending growth has primarily been driven by challenges faced by banks, including consolidation, increased regulation and a low interest rate environment and predicts its future will be highly dependent on similar factors. It said it can be difficult to forecast future reductions in bank lending and also queries whether the direct lending sector will be resilient to higher interest rates.

It also states that recovery rates for direct lending loans in distress are largely unproven in Europe, however S&P LCD data suggests syndicated markets have shown better recoveries for covenanted deals. With direct lending transactions typically retaining maintenance covenants, unlike the current syndicated market, SBS said direct lending may be able to retain positive recovery rates.

The covid-19 crisis has overall been positive for the asset class, the report states, with valuations proving to be substantially less volatile than public market valuations. Responses to the crisis by central banks have depressed yields which have historically placed pressure on bank profitability which may mean many more mid-market companies are viewed as too small to issue syndicated debt and will therefore be reliant on private debt funds.

The impact on liquid bond markets, where investors can no longer earn more than around 3 percent unlevered, is also likely to drive an even greater search for yield and thus increase demand for private debt further relative to public markets.