This article is sponsored by EQT Partners
With the world’s central banks seeking to calm nerves by pumping liquidity into markets and European regulators giving banks wiggle room on meeting capital requirements, investors are braced for a wild ride in 2020. We spoke to Paul Johnson, partner at EQT, to ask for his assessment of the challenges and opportunities ahead.
How would you characterise the current sentiment in European mid-market lending?
We saw the direct lending market continue its rapid growth in 2019 across the continent.
Smaller regions, in particular, were accelerating. A good proportion of our portfolio is in the Nordic region, where we did another four deals last year. Growth, to date, has not been fuelled by banks’ unwillingness to lend; that may have been the case way back at the start of the last financial crisis, but it hasn’t been the case in the years since.
Instead, private equity firms have been keen to work with direct lenders.
What impact will the coronavirus have?
With the ongoing coronavirus outbreak, we do expect to see some reduction in merger and acquisition activity.
It’s hard to quantify that in days and weeks, but we have previously observed that direct lending has continued to grow in uncertain periods, as was the case after the Brexit vote. That said, there is some potential for knee-jerk reactions, and banks have been guilty of that in the past. But any reduced appetite from them to lend would only accelerate the appeal of direct lending. There will be some investments more impacted by coronavirus than others, and that’s why it could be a defining time for direct lenders.
We’re heading into a period when everyone’s portfolios will be tested. In six to 12 months’ time we will see considerable differentiation between direct lenders and their portfolios. It will be much easier for investors to see who is taking more or less risk. Coronavirus will test portfolios for sure and everyone will have some issues. It is naive to think you won’t.
The months ahead will be all about understanding risks. We will benefit from having strong portfolio monitoring and restructuring capabilities. We have developed this toolkit within our team and it is evidenced in our strong track record since 2008. We have always challenged ourselves to do this every day, before we’d heard of coronavirus, because we recognise that some businesses that are consumer-facing will be hurt far quicker and deeper than others in challenging times; that’s why we have no retail exposure, for example.
This is when the portfolios that you have been deploying for the past two or three years will be tested. Even before the coronavirus, people were saying we were “late cycle”. At a Private Debt Investor event, where I appeared on the panel, I was asked whether it was a time to become more defensive. My response was “no” because it is already too late.
How do you anticipate LP sentiment responding to the challenges ahead?
The most obvious response is with regard to where investors are in the capital structure. In challenging times, senior secured is obviously the best place to be. If you’re invested in subordinated or junior debt, you are more vulnerable.
Being a lender of less than 50 percent loan-to-value is also a good place to be. You should expect more resilience in recessionary or challenging times. There’s been too much emphasis on the ‘V’ of LTV in recent years, and valuations have been too high for too long. That may well prompt a correction.
However, if your average LTV was less than 50 percent, there is room for a change to the valuation without affecting returns on a portfolio basis. We have always had a style of investment that’s a bit more defensive in terms of sectors. We have targeted returns for the least possible risk and hope this will pay off as times become more challenging.
You say you’re a bit more defensive in your sector choices. Can you elaborate?
Around 85 percent of all our deployment in direct lending has been in healthcare, services, and technology, media, and telecoms. That has been the case ever since we started direct lending six years ago. We have always assumed that will be what our investors want us to do. Those sectors tend to enjoy stable customers through cycles, through challenges like this. They have low capital intensity and are highly cash-generative. We have seen strong deleveraging across the portfolio as a function of that.
Where will we see significant change in investor behaviour in the coming months?
One area is in analysing environmental, social and governance metrics. Until now, it has been very easy for lenders to hide behind excuses, saying they don’t own shares in certain companies, so it is difficult to change policies. But this is going to become a bigger challenge for direct lenders, in the way it has for private equity owners.
For many years, we have been negative screening, declining investments because of ESG concerns. But we’ve moved on from that.
Now we have a framework where we assess the product or solution that a company provides and evaluate how the company acts and practises. It is about understanding and profiling the portfolio to make sure it doesn’t have a negative impact.
Yes, there are certain sectors we would not invest in, but every business can improve. We take a questionnaire to assess every investment. We ask our portfolio companies to fill that in and map out where they are. The reaction from some private equity firms can be interesting. While some are happy to fill it in, others are not. But we think it’s important.
There are plenty of examples of where companies that score badly on ESG later struggle with regulatory changes, higher taxation charges or a change in customer sentiment for the product they offer. In the long run, ESG does correlate with returns.
Do you anticipate any structural changes in market behaviour in 2020?
There will be some M&A activity. We have already seen that some sponsors have shown a reduced appetite to approach multiple lenders.
This trend started in 2019, but it seems that sponsors are increasingly keen to work with direct lenders with which they already have a relationship. Looking at our 2019 activity, 20 percent was additional facilities to strongly performing portfolio companies, and around 40 percent of our work came from private equity firms with which we had not transacted before.
The remainder was an increasing volume of new transactions originated directly from private equity firms with which we have done business previously. I guess there is a degree of comfort in familiarity.
What’s the longer-term outlook for European mid-market lending and how might this create challenges or opportunities for lenders?
Longer-term (post covid-19), there will be continued growth in the regions across Europe, particularly the Nordics. Growth is also now well-established in Germany and increasing rapidly in places like Spain. There is growth across many parts of Europe.
That said, in the near term there will be some businesses where it is harder to quantify the impact of coronavirus, and inevitably some cyclical assets.
What that does mean is there is likely to be more competition for highly defensive assets in this market, certainly in 2020.
There will be competition for private equity firms looking to acquire, and lenders wanting to become a bit more defensive than they have been.
This is also an opportunity for the investors to differentiate their managers. In a benign environment, it’s harder for investors to truly assess who is taking more risk for the return.