This article is sponsored by Fidelity International
Against the backdrop of inflation and slowing growth, what should investors expect from this cycle in private credit?
Marc Preiser: Having been around private credit for decades, the one thing we know is that the next cycle is not going to be the same as the last. We are facing external factors that this market has not seen before: the direct lending business is relatively new in Europe and most growth happened since the global financial crisis. Participants have not been through the complex set of challenges we face now – rising inflation, supply chain challenges, geopolitics, interest rate hikes and widening spreads.
Back in 2005, LIBOR was at 4 percent, so this isn’t unprecedented for those of us with experience of investing through multiple cycles. But it is a first for direct lending, which has generally grown up in a benign environment. It is actually a very exciting time to be investing because people have to think harder about how to approach opportunities, and we are going to see different competitors taking different paths.
The banks have become more circumspect and right now we see a pattern of retrenchment. Liquidity in middle markets will be affected to an even greater degree, enhancing the attractiveness of direct lending as a solution for middle market borrowers. In an uncertain environment, manager differentiation, which has been largely absent from direct lending for the last few years, is going to become more important, and we anticipate interesting opportunities over the next five years to differentiate with bottom-up, credit-focused analysis.
Raphael Charon: When we are ready to come into the market, we will be able to benefit from the correction: we know where interest rates might go and the impact that will have on borrowers, and we are able to adjust to that when picking credits. It is a difficult environment but we don’t have a portfolio of legacy transactions structured at the peak, so we can benefit from more conservative terms, lower leverage multiples, higher pricing and documentation trending in our favour.
One of the strongest arguments for investing in private credit has been the search for yield. Do you think that’s still valid now that yields on public credit have risen?
MP: It has been consistently valid for decades. When we talk to investors they obviously want to hear about strategy and the companies that we are looking at, but they also want to hear about interest rates. They have broader fixed income portfolios, so they have exposure across high yield, corporate bonds and leveraged loans, where they are taking a hit. That is not how this market works.
Direct lending is a very consistent, stable, floating rate, index-rate-plus spread-based market – we don’t have that kind of volatility. If you look at the loans written 18 months ago, they should probably be priced differently now, but we are all benefiting from the floating rate on the base rate. We are up to 10 percent or 11 percent yields, though there is no promise that will last.
These are closed-end, long-term funds, so we have to think about interest rates in the context of that term. Rates are great now but we are taking some duration risk. Still, this is a buy-and-hold product, a capital protection product and a risk protection product. We make sure we preserve capital and return interest to our investors.
We are also asset selectors, picking 25 to 30 assets that we really like, and we are much closer to our borrowers in direct lending, giving us more control and influence over outcomes. We have covenants and terms in our documentation that provide stronger protection. So while we think that losses will be elevated going forward, they are still going to be very low, with the asset class benefiting from historically low defaults and high recovery rates.
Which part of the European direct lending market looks most attractive at the moment?
MP: We are very focused on the middle market and have been for the bulk of our careers. We think that provides the best opportunities for the key reason that we are much closer to the asset. We are either bilateral lenders or there with a couple of others. Here the relationships really matter. We have a much better sense of the strategy and do pretty intensive third-party due diligence.
We particularly like the core mid-market of €5 million-€30 million EBITDA companies. If you look back 20 years, that is what everyone was doing and the syndicated loan market was taking care of the bigger deals. Now we see our competitors chasing larger-cap transactions but we like the middle market where we can partner with the sponsor and the borrower. They are using our capital because it helps enhance their yield and the debt-to-equity ratio is more positive, the leverage levels are lower, pricing is a bit higher but most importantly we are closer to the borrower.
Right now that market is under-served, yet across Europe there are thousands of SMEs looking for capital.
RC: Many of our competitors have outgrown that core mid-market and do not focus there anymore. And those lenders that are there tend to seek higher yields closer to unitranche or what used to be mezzanine yields. But some borrowers don’t necessarily want that.
Is the slowing macroeconomic environment having an impact on the opportunity set?
MP: There is a slowing in the macroeconomic environment but that hasn’t really hit dealflow. We still have a robust set of opportunities, and they are probably better than in the past. What we are seeing is that sponsors are looking for partners now. They want to make sure they get their deals closed, so that relationship aspect is more valued, with less focus on financial engineering and leverage. The concept of a smaller group of lender partners is back in vogue.
RC: Borrowers also want support on deals going forward, so relationships really do matter. We currently see a hybrid process where you have banking structures being proposed to borrowers and a unitranche structure being offered on the same transaction. One will be more conservative, with a lower price, covenants and lower leverage, while the unitranche could have leverage above 6x and pricing that is higher. In fact, many borrowers want something in the middle: stretch senior that provides more flexibility at more conservative leverage than unitranche with slightly cheaper debt. That is an opportunity for us as it fits our pricing strategy and our yield targets.
What does that mean for origination across Europe?
“We anticipate interesting opportunities over the next five years”
RC: In order to address the needs of sponsors across the continent we have developed a pan-European team and a local approach which builds on Fidelity’s long-standing presence in European markets. For the core mid-market space it is critical to be able to be closer to sponsors, so we have people in London, Frankfurt and Paris and are also covering Benelux, Southern Europe and Ireland. To address mid-market sponsors we need to be local and build relationships with the decision-makers. We need to be reliable, transparent, efficient and predictable: it is okay to say no, but you have to say it quickly.
MP: Even though we continue to see strong bank bids in certain places we are certainly seeing direct lending eating market share. This macro environment will continue that cycle. A decade ago, the bank bid was very strong in France, Germany and elsewhere, but it has turned the other way and this current climate, with generally more conservative behaviour from banks wanting to conserve capital, will drive that further. We see the bank pullback happening and that helps us on origination.
Does that personal relationship with the borrower help with ESG engagement?
RC: These personal relationships come from sponsors that we have known for decades, who know that we are reliable and that is why they call us. They also know we can be constructive around providing structures that address their needs.
“For the core mid-market space it is critical to be able to be closer to sponsors”
ESG is extremely important to us. We have the strong support of Fidelity’s expert ESG team to work with us on validation of ESG requirements and help our sponsors develop the initiatives they need to improve standards. It is not just about relationships with deal teams in the PE firms now but also with their heads of sustainability. Many sponsors have developed strong ESG platforms so we can build a dialogue with their experts, and with management teams, to provide support as they develop their ESG strategies and improve their metrics.
MP: You can see a pathway whereby Article 8 is going to become necessary, because it is difficult to get attention from investors without it in direct lending now. Fidelity takes this very seriously and has built a big team around it, and we will lean towards sponsors that have good strategies and processes in place.
Sitting across the table from management teams gives us the ability to tell them what we want and help them do it. That is unique to this market. As a lender, we can actually have some level of influence.
So we will tilt towards companies that have a more positive outlook in the first instance, and two or three years from now we expect people to be even more discerning about how they think about ESG. The focus will shift away from Article 8 as a label and towards what it means in practice, and we think the mid-market is a unique hunting ground for achieving real alignment with sponsors and management on these topics.
Marc Preiser is portfolio manager and Raphael Charon is head of direct lending origination at Fidelity International Private Credit