Book Excerpt: New sources of liquidity in the European market

In an excerpt from PEI Media’s forthcoming guide ‘Investing in Private Debt’, ICG’s Max Mitchell maps out the opportunities and challenges facing private debt fund managers. 

The provision of private debt to the European buyout market has historically been dominated by the European banks, which typically funded their loan books using their balance sheet. However, following the recent financial crisis, the European banks’ ability to provide liquidity has significantly contracted and this contraction is negatively impacting private equity transactions (both involving existing portfolio companies and potential new buyouts) in Europe.

We believe that for the European buyout market to return to a more ‘normal’ state (including dealing efficiently with refinancing requirements of existing private equity owned portfolio companies), it will need to transition from a heavily banked market to a more balanced bank and institutional market, as has happened many years ago in the US.

The evolution of non-bank lending in Europe 

Unlike the US, Europe remains primarily a banking market. Banks provided 51% of European buyout finance compared to a mere 15% in the US in the first 9 months of 2012. The US market benefits from a deep institutional market which provides consistent liquidity and is highly developed and diversified, including CLOs, mezzanine funds, direct investments by insurance companies, credit hedge funds, distressed debt funds and Prime Rate funds. The latter are a material component of the US market and raise capital from both retail and institutional investors.

By contrast, the European institutional market is still in its infancy.  Historically the only significant non-bank lenders in the European private debt market have been CLOs and the independent mezzanine funds.

As the traditional bank and CLO lenders exit the market, we are seeing a new breed of non-bank lenders coming to the fore. From a borrowers’ perspective the decision as to whether to work with private debt funds will be driven by a wide range of matters specific to each borrower and / or each deal.  However, from our experience to date, most borrowers have been open to working with private debt funds, particularly those that are managed by fund managers with whom they have existing relationships. Some other key considerations are:

Reduced complexity: private debt funds are generally looking to make significant investments in individual transactions. Fundamentally this means that deals can be done with smaller clubs or even on a bilateral basis, which has the benefit of significantly reduced complexity.

Certainty / cost: private debt funds are generally take-and-hold investors, which removes need for onerous syndication language / risk of market flex. In addition, given their decision structures, private debt funds are typically more fleet of foot in terms of delivery of approval.

Flexibility: compared to a conventional bank-led financing, private debt funds are often more flexible around loan features (including non-standard amortisation) as long as the overall balance of risk is appropriate.  We are aware that a number of the private debt funds do require non-call protection but we note that it is typically significantly shorter than that required by traditional mezzanine funds and therefore is more suitable for refinancings where the sponsor is not looking to remain in the investment for a further three or more years. 

What type of transactions will private debt funds target? 

It is likely that new funds will broadly focus on two different investment strategies, each of which will be more relevant depending on the particular circumstances of the transaction.

The first is to partner with remaining active European banks to provide borrowers with capital solutions on a ‘club’ basis. This is essentially a bank replacement strategy and is targeted at performing, consistently structured, ‘mainstream’, borrowers. Most of these ‘clubs’ would comprise of typically 2-6 lenders, including at least one bank. Loans in these ‘clubs’ would typically be senior secured loans pricing at LIBOR (or Euribor) plus 550bps – 850bps margin with arrangement fees.  We believe that this is the strategy that is most likely to become the primary funding solution to replace the bank and CLO liquidity that has left the market.

The second is to focus on those transactions which the European banks are typically moving away from as they reduce their risk tolerances.  Whilst the return on these transactions may be higher, they inherently include a higher level of risk, including higher leverage or potentially sub-ordinated debt investing.  In some instances, this strategy will compete with the banks where the quality of the business is on the margin.  This is more of a bank substitution or bank disintermediation strategy, and often there will be no bank present in the syndicate. We see this as more of an extension to the traditional mezzanine market and, as such, demand for this product will be lower and these funds will establish themselves as a niche product.

Who will private debt funds appeal to and how do they invest? 

In our experience only a few of the larger institutional investors in Europe have historically had any knowledge of, or exposure to, the private debt asset class (exposure was generally via investment in the senior (‘AAA’, ‘AA’ and ‘A’ rated) debt tranches in CLOs).  Private debt was generally ‘below the radar’ for institutional investors and was perceived not to be able to deliver sufficient returns to compensate for illiquidity and capital charge treatment.

In our experience the increased interest in the private debt asset class has been driven by the following factors:

  1. In the current capital market environment it is very difficult for institutional investors to generate sufficient returns to meet their core needs for (1) regular income distributions and/or (2) long term liability matching. 
  2. The returns available from investment in European private debt are currently significantly higher than both the long-term historic average and the equivalent returns in the USA. Modelled returns based on current deals in the market are perceived to be sufficiently attractive to compensate institutional investors for the reduced liquidity of the investment and the capital charges of lending to relatively small, sub-investment grade borrowers. 
  3. Other attractive features that appeal to institutional investors are the lower volatility of returns (compared to for instance, the high yield market), the ability to actively manage credit loss risk through due diligence and documentation, a low correlation to other mainstream financial markets and low duration risk protecting against inflation.

Having made the decision to allocate to the asset class, the next key consideration for investors is to select a manager with which to work. Based on our experience when undertaking due diligence the key considerations for most investors are:

  1. Reputation: because the asset class is new to most institutional investors, there is naturally a degree of apprehension from an investor’s perspective, given their lack of familiarity with the asset class.
  2. Track record – there are very few managers that have a track record as both an experienced investment manager of third party money as well as a creative investor in private debt.  Investors want managers that can demonstrate the credit analysis and selection skills necessary to deliver the expected returns.  
  3. Proven origination platform: institutional investors want to invest in teams that can demonstrate the ability to consistently originate high quality investment opportunities.  In our experience, a conversion rate of 10% of all new investment opportunities into completed investments is a reasonable working assumption.  Therefore, to build a diversified portfolio requires a high flow of new investment opportunities.
  4. Execution capability: constructing a reasonably diversified portfolio of loans within the direct lending space is a highly labour intensive process and requires a team of proven investment professionals. The nature of the origination and execution process, along with lower conversion rate, means that the team set up for a direct lending platform needs to be tailored around this process, especially when compared to a fund buying solely syndicated loans. Close monitoring of the portfolio is also a key part of risk management.  Therefore managers need to have invested in building a large team of experienced professionals. 

Challenges and threats to the growth of European private debt funds 

Direct lending private debt funds certainly have the potential to address a significant part of the liquidity requirements of the European buyout market. However, this is still a nascent market in Europe and there are a number of challenges to the development of private debt funds as a mainstream lender alongside the clearing banks:

  1. Illiquidity: private loans for mid-market borrowers are generally an illiquid asset class and therefore it is difficult for fund managers to offer investors any form of redemption liquidity.  In the US fund managers have found a partial solution through the use of listed Business Development Company (BDC) structures and exchange traded mutual funds often referred to as prime rate funds.
  2. Proof of strategy: given the state of evolution of the European direct lending market, the experience of investors in the first wave of funds will be critical in the successful long term development of the market. The diverse range of marketed returns and strategies will make wholesale comparison unlikely.
  3. Defaults/ Recoveries: a critical attribute in the appeal of senior secured debt is the historically low default rates and comparatively high recovery rates. The continued evidence of these characteristics will remain paramount to further evolution of the market
  4. Regulation: a number of European governments have historically been opposed to the meaningful development of the non-bank lending market. This has typically manifested itself is particularly prescriptive legislation as to who can provide financing for companies and how it should be done. However others, including the UK, have taken the opposite stance and more recently been highly supportive of direct lending funds which contribute to kick starting the economy by making financing available to mid-market companies.
  5. In addition, regulators for pension funds and insurance companies have had a clear bias towards forcing these institutional investors towards marked-to-market, liquid assets.  The uncertainty over the timing and scope of the Solvency II framework has resulted in insurance companies being highly hesitant in investing in new asset classes in an ever evolving capital requirement framework.

Conclusion 

As banks continue to reduce their lending appetite and CLO capacity shrinks further, we expect that the European buyout funding market will eventually transition from a heavily banked market to a more balanced bank and institutional market, as has happened many years ago in the US. Economic and regulatory uncertainty has slowed this process down but there is evidence of momentum building up as more investing institutions seek solutions to enhance the yield of their portfolios.