Europe’s direct lending market has a problem. Almost everyone agrees it has come through the pandemic in surprisingly fine fettle, with a study from Oxford University’s Saïd Business School suggesting Europe could be bigger than the US for direct lending within a decade.
Yet with many managers pursuing similar strategies, it can be tough for limited partners to discern the differences between them. Competition for commitments is greatest among funds active in the upper mid-market on sponsor-backed deals. However, standing out at a time when meeting LPs face-to-face is off-limits is hard for everyone, say market participants.
“Direct lending, more so than anything else, is congested,” says Tavneet Bakshi, partner and head of EMEA at placement agent FirstAvenue. “It’s not just difficult for newcomers, it’s also very difficult for established platforms as well if they are looking to broaden their investor network. Even the big brands are finding it a challenge.”
So how should a manager stand out from the crowd? Here are five ways to get ahead.
1. Carve out a niche strategy or approach
Finding a story that is different from everyone else’s frequently comes down to carving out a new strategy or taking a unique approach.
One popular way is to target smaller loans. Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens, says: “We start to see differentiation where managers can do smaller transactions and focus more on the lower end of the mid-market. There, you have some great performance from groups that focus on businesses with EBITDA of €10 million-€20 million, and we think that’s an underserved part of the market with better structural protections and better risk-return dynamics.”
Jaime Prieto, founding partner at Kartesia, which has gained a reputation for off-market deals, agrees: “There are plenty of managers doing sponsored deals in the €50 million-€150 million bracket, where the barriers to entry are relatively limited. At the lower end, where the GP needs to drive the deal and you really need a network of local offices to succeed, there is much less competition.”
But there are plenty of other niche approaches too. Prieto recommends doing more than just direct lending: “A broader approach to private credit that complements direct lending with origination via the secondary market, where we can replace existing lenders at a discount, allows us to seize the best opportunities throughout a full credit cycle. That has been a real differentiator for us.”
In senior lending, the managers that stand out are the ones offering loans that are not just cashflow-based but are instead secured against specific assets, such as property, plant equipment, inventory or renewables.
Then there is the sector approach. “We have certainly seen some of the covid sectors showing up,” says Bakshi. “Healthcare is a trend at the moment, whether healthcare direct lending or healthcare structured credit. That resonates with US LPs in particular, who are more comfortable taking a sector-focused approach, whereas in Europe there’s still a preference for more diversified exposure.”
Bakshi says there are innovations around structure: “One of the things we find interesting [are] evergreen or open-ended structures, particularly at the larger end of the market, that can potentially offer some level of liquidity.”
Finally, placement agents say LPs are often keen to hear from managers that can commit from their own balance sheets. This is favoured by Frédéric Giovansili, deputy CEO at Tikehau Investment Management. “We don’t view ourselves as an asset gatherer,” he says. “We have a really large, strong balance sheet that allows us to invest as an LP alongside other LPs. So we always have skin in the game way beyond carried interest, and our story has always been about being a co-investor.”
2. Step away from private equity sponsors
Many investors are looking for funds that focus on sponsorless deals, according to Christian Allgeier, director at FirstAvenue.
“We see some LPs looking to get into the non-sponsored side and struggling to see managers in Europe,” he says. “There aren’t that many that offer pure non-sponsored funds, despite some claiming to do so.”
Kartesia likes sponsorless deals. “Sponsorless companies deserve a lot of attention,” says Prieto. “They have always been a focus for us, because we believe you can proactively drive investments in some really good, high-quality companies, with less competition and more scope to customise the financing to the needs of that particular business. You can get anything from two to six additional percentage points on returns.”
Griffiths says: “It is certainly good to be able to diversify your dealflow away from sponsors into businesses that are not PE-owned, whether that means they are publicly listed, entrepreneur-owned, family-owned or employee-owned.”
3. Expand your office network
Country-specific funds are rare in Europe, largely because there is not enough diversification potential in most European markets to achieve a deep portfolio.
Instead, building an office network excites LPs, says Griffiths: “It’s important to build diversification across countries and have a local presence in the countries you’re investing in. We like to see groups with expansive office networks, even if they are smaller managers, so that they can demonstrate they can originate transactions from the ground up.”
Tikehau just opened an office in Germany, its eighth in Europe and 12th globally. “LPs really care about origination capabilities, and they recognise that Europe is not a single geography,” says Giovansili. “Instead, there are different funding dynamics and different bankruptcy laws in each country, so you can’t do business in Germany in the same way that you do in Spain, France or the UK. LPs want managers that put boots on the ground and develop a differentiated approach in each market.”
4. Make the most of virtual opportunities
Fundraising is challenging when meetings cannot happen in person.
But there may be upsides. Campbell Lutyens’ Griffiths says investors “can screen a lot more managers virtually than they ever could by running around the world. They are requesting video conferences with people they have never met before, making manager selection much more efficient”.
That has been Kartesia’s experience. Prieto says: “We have found some very large LPs proactively reaching out to us to start establishing a relationship, and within four months they have committed capital.” Another benefit is the on-screen ability to show off your systems. Griffiths says: “We have clients that can demonstrate their reporting and IT systems virtually very effectively, taking advantage of the opportunity to show investors exactly how those work.”
Giovansili adds: “Our track record, our alignment of interests, is very important to LPs, as is our disclosure and the granularity of the information we provide, where we have been told we stand out. That was something we were able to demonstrate during virtual meetings.”
5. Highlight your expertise
One thing to come out of 2020 is an enhanced ability for investors to conduct due diligence on managers’ track records through a difficult period.
This has revealed some large managers to be lacking and created opportunities for newcomers. “Due to covid, one of the areas of focus for investors has been the ability of managers to really work through difficult situations,” says Prieto. “The experience we had from 2008-09, and then more recently, has really given us the credibility to show that when things don’t go according to plan we have the internal capabilities to get through that and maintain investment discipline.”
Finding ways to communicate that expertise is key. “You have got to find ways of making your story and your product stand out,” says Bakshi. “We’ve found you get more traction being a content provider and thought leader – by doing deals and talking about those deals rather than just sending out another fund pitchbook.”
Could Europe eclipse the US?
Europe’s direct lending market could become bigger than that of the US over the coming decade, according to a report from Oxford University’s Saïd Business School commissioned by Pemberton.
The report says Europe currently trails the US in terms of direct lending AUM as a percentage of GDP but that there is significant room to catch up if European direct lenders can increase their AUM by a further 50 percent.
“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 says.
It notes that direct lending growth has primarily been driven by the challenges faced by banks, including consolidation, increased regulation and low interest rates, and that its future will be dependent on similar factors. It says it can be difficult to forecast reductions in bank lending and 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 suggest syndicated markets have shown better recoveries for covenanted deals. With direct lending transactions typically retaining maintenance covenants, unlike the current syndicated market, direct lending may be able to retain positive recovery rates.