Opportunity and risk: a decade of change in European private debt

The last 10 years have seen enormous growth in private credit. Success over the next decade will depend on avoiding the crowds and having a strong operational resource, argues Hayfin’s Andrew McCullagh.

At Hayfin, we had cause to reflect on our firm’s growth this summer, as we celebrated our 10th anniversary. But it is also an opportune moment for retrospection among the wider European private credit industry, approximately a decade after it emerged out of the financial crisis. Tracing private credit’s evolution into an established asset class sheds light on the important role that it now plays in the European economy and its future prospects.

Within the private credit universe there exists a diverse opportunity set. It encompasses many strategies and variants, reflected in the proliferation of specialist funds over the past 10 years. Alongside the multitude of direct lenders providing senior-secured loans to mid-market businesses, there is a broad array of alternative credit products that comprise variants such as asset-backed lending, mezzanine debt and distressed debt.

Each variant has followed its own trajectory. However, the roots of European private credit altogether lie in the introduction of Basel II and the need for banks to improve their balance sheets post-crisis, collectively compelling them to reduce their exposure to leveraged lending.

Within direct lending, a lender’s market existed in 2009, where borrower demand outstripped available capital and few dedicated funds had been established to supply credit. Only a select number of institutional investors globally understood the product’s potential and, even as awareness grew, LPs struggled to determine how they would allocate capital to the asset class. Those few new entrants were primarily focused on financing leveraged buyouts, as the easiest part of the market to access and the easiest credit to underwrite.

Since then, the asset class has expanded rapidly. Funds now account for more than half of mid-market leveraged lending in Europe. This has been driven by both push and pull factors: pension funds and subsequently insurers have come to value direct lending as a product, while growing regulatory requirements mean banks must continue to ration their capital in ways they didn’t have to pre-2008.

However, the volume of new entrants has produced a competitive, crowded and heavily intermediated market – particularly when financing mid-market buyouts, which are straightforward to source and often brought directly to funds by a growing number of debt advisers. These competitive dynamics have eroded the quality of documentation and, consequently, the risk-adjusted returns on offer are weaker.

Outside of direct lending, most opportunities a decade ago were also driven by the crisis – largely corporate distress and non-performing loans (NPLs) sold by banks. Five years ago, the commodities downturn opened opportunities for asset-backed lending in sectors including oil and gas. Meanwhile, real estate NPLs became more prevalent in markets such as Spain, because of the lag in banks divesting these assets to government-backed agencies and the loans being re-sold.

Recent years have been defined by a low default rate, reducing the supply of distressed debt for special situations funds and limiting demand for asset-backed financing solutions that are typically more in vogue in the credit cycle’s early stage. For special opportunities investors today, Europe remains a broad and shallow market, especially when compared to the US.

This current environment demonstrates the need for a broad investment mandate for European private debt investors, irrespective of your strategy.

In the crowded direct lending market, generating strong risk-adjusted returns requires greater emphasis on origination. It is imperative that you see as broad a range of senior-secured opportunities as possible, rather than just those your peers are bidding against you on or have already declined. Europe is a patchwork of different jurisdictions and to originate deals beyond those brought to your door by sponsors and intermediaries, you need a full-time presence and established local lending relationships in the geographies in which you invest.

Across other private credit variants, a broad investment mandate allows you to target the niches that are moving from borrowers’ to lenders’ markets, even in a low-default environment. The most attractive risk-adjusted returns are found in difficult-to-access sectors, such as healthcare or shipping. These are sectors where capital is shorter and competition less active as a result of fewer funds possessing the requisite specialism to underwrite loans.

While these dynamics pose testing questions of managers, they also demonstrate the significant role now played by European private debt funds. With all indicators pointing towards continued and extended regulations on banks, this is unlikely to be diminished. Funds are here to stay and their market share is only likely to grow.

However, a turn in the credit cycle will present unchartered waters.

The quality of the loans extended by European direct lending funds is yet to be tested in a period of downturn. Funds that have prioritised the development of workout capabilities will be better placed to manage the consequences of this – particularly those with local expertise, as restructuring regimes vary across geographies. Lending is easy, if you can get your money back.

The next downturn will also drive a rise in special opportunities across Europe. These types of investor are often characterised as ‘vulture funds’; however, this fails to recognise their role in the deleveraging of banks and other institutions. Such funds have been established to manage these assets and make a crucial contribution to the clean-up following a downturn.

European private credit has grown rapidly and changed profoundly from a standing start 10 years ago. Market participants must be prepared for a similar transformation in the landscape over the next decade, if they are to continue to rise to the challenges and opportunities that lie ahead.

Andrew McCullagh is a managing director at Hayfin Capital Management and a member of the firm’s management committee.