Kartesia on the evolution of the European lower mid-market

Direct lending has surged in Europe over the last decade, as banks retreat from core markets, says Laurent Bouvier, founder and managing partner at Kartesia.

This article is sponsored by Kartesia

How would you describe the evolution of the opportunity in European lower mid-market lending over the past decade?

Laurent Bouvier of Kartesia
Laurent Bouvier

When you look at the 10-year picture of direct lending, France and the UK represent 60 percent of all the deals structured over the past decade, according to the Deloitte Private Debt Deal Tracker. Germany and other European markets, such as Benelux or Italy, are growing as a share of that; however, we have shifted from a highly concentrated market where the UK had more than half of all deals to the current situation, where it now represents just over 30 percent.

Private credit is increasing penetration in every market in Europe, with growth coming from the least penetrated markets, such as Germany, Benelux, Central and Eastern Europe, Spain and Italy. For direct lenders it has become even more important to have a local presence as opposed to having one office in London covering half of the market.

Overall dealflow has multiplied by 7.5 times over the past decade, with European banks going from representing 61 percent of leveraged loans during the global financial crisis to just 12 percent today. That bank retrenchment is still at play. In Europe, we have shifted completely from a market where the banks were the final holders of these loans to them now underwriting and distributing loans but not holding anything significant on their balance sheets.

What is the key to successful origination in that market?

The key selling point for direct lending today is the fact that it is a one-stop solution, where most of the time borrowers have just one direct lender as opposed to a club of banks. That means direct lenders can offer deal certainty and speed of execution. In the most efficient markets, such as the UK, a deal can be done in four to six weeks, which banks will never be able to match.

The other attraction is the cost-effective simplicity of the product. We are more expensive than the banks, but our financing and flexibility will be a catalyst for value creation, particularly where we are funding situations where the cost of debt is not the sole decision-making point for the borrower.

Finally, there is scale. Historically, direct lenders could underwrite €25 million to €200 million, so the size of deals was limited. Last year, the Access Group issued the largest unitranche ever done in Europe – of close to €4 billion – with eight direct lenders clubbed together. Direct lenders have now broken through the ceiling and have become relevant for large-cap borrowers. They can now replace banks or high yield bonds with a viable alternative solution.

On the other side of the spectrum, you have the lower end of the mid-market, where borrowers traditionally turned to local banks and local funds. The mid-market continues to be very attractive, although at a cost of high competition, resulting in a potential commoditisation of what they offer. Managers willing to differentiate need to either go into the very large deals where competition is lower or to go to the lower end of the mid-market where the sophistication you can bring sets you apart.

The other big evolution is on the investor side. To remain relevant, managers need strong positioning. There has been consolidation in the asset management world, LPs are growing and they need scale. They are consequently looking for either very large direct lenders that can put to work very large AUMs on a handful of deals, or those that can take advantage of the opportunity in the lower mid-market with pan-European platforms.

From a fundraising standpoint, it can be very difficult for local or regional players – to be successful you need to offer all the elements and be perceived as a credible lender with a good reputation among borrowers.

How do you expect the challenges and opportunities in that market to change?

Post-covid, given the macro environment of rising interest rates and high inflation, we are seeing further bank retrenchment, with banks being increasingly risk-averse. We believe this will be a further catalyst for growth in our market. We see our dealflow increasing because a lot of companies are faced with tightening liquidity that may create a difficult turning point in their cycles.

“Interestingly for us, the total value of CLOs has been overtaken by
direct lending”

Management teams that increased pricing dramatically post-covid – in the face of high inflation in raw materials, staffing and energy costs – were probably able to do so because everyone was doing it. But they have most likely secured that procurement for this year and next year, and now their raw material costs are coming down and customers know that.

That means procurement is secured at higher prices, but customers are challenging price increases, creating a squeeze on cash generation that might really become a relevant point at a time where loans are potentially close to maturity with borrowers looking to refinance.

While we see increasing dealflow, we also perceive increasing cash pressure on the balance sheets of companies. As such, we need to remain very focused and continue to be selective.

What does the opportunistic credit landscape look like across Europe today?

For us, the opportunistic credit play is easy. We do not have a crystal ball, but companies increasingly need a flexible capital structure to navigate cycles and strategies to make sure they can deliver on the value creation side. In some cases, banks are a good partner, but more and more we see that the flexibility, even at the cost a direct lender will offer, is a better option.

We are excited about opportunistic credit because we believe we have never been so relevant to a lot of borrowers in the market. It is not that they are in dire straits, but our financing can really be a win-win catalyst for value creation for stakeholders, management teams and the direct lenders. We give them someone to speak to and someone who can be flexible, which is really valuable.

How has the market developed in the last decade?

What we like in Europe is that every jurisdiction has a different momentum, so the opportunity set can depend on any number of other factors. Each country has a different appeal but each of them is a good market, either because they are growing, like the German-speaking countries and the Benelux region, or because there is less competition, like the UK today.

While the sponsorless opportunity has grown markedly in the last decade, we believe we are still early in the adoption penetration curve. There is a massive opportunity in sponsorless direct lending, with far more borrowers open to this solution as opposed to just relying on local banks.

There is increased competition. More than ever, managers need to be able to scale their business to intensify their relationships with GPs and grow with the market. In such a fast evolving and fast growing market, agility is key.

The market for structured credit and CLOs in Europe has changed a lot. How do you see that strategy delivering for investors moving forward?

Interestingly for us, the total value of CLOs has been overtaken by direct lending. There is still a very interesting CLO market in Europe – we have been in the market for 10 years, so we feel quite at ease navigating these cycles. Currently, there are plenty of opportunities in the investment grade part of the capital structure. If you were to compare the returns you can get on the investment grade side with similar rated corporate bonds, returns can be up to three or four times higher.

There is increased interest from investor s in the CLO market and we support that. There is still a lot of volatility to arbitrage on, but it boils down to one’s ability to really do fundamental credit analysis on the tail risk of the underperformers in the portfolios.

We are yet to see any real increase in default rates; for us the CLO market has been a very positive one for the past decade and each year we continue to see some good entry points.

The canopy of trees in a forestImpact debt is emerging as a growing credit strategy, just as ESG more broadly is moving up the agenda for debt funds. What are your predictions for the way in which private credit will address ESG and impact over the next decade?

We launched an Article 9 compliant fund a year ago. Because of market repricing and macro volatility, there has been a disconnect between what we can find in terms of dealflow and the support we can get from LPs. ESG today is not strong enough to trigger the interest of an LP to invest if the returns are not on a par with what they can get in the more liquid fixed-income market.

On the dealflow side, we have seen massive interest because a lot of money has been raised in private equity for dedicated impact strategies. We have already completed three deals in our impact finance fund. Returns are slightly below the typical unitranche but with a risk profile that is much lower; with leverage of 2.5 times on average, the risk-adjusted returns are similar to what you would get in credit opportunities or senior loans.

We are extremely excited by this opportunity. If the dealflow is there, we know that over time we will convince LPs there is a clear path to put money to work in a market where they can make a social and environmental difference, while still making good risk-adjusted returns.