It’s fitting that the location for Private Debt Investor’s European roundtable this year was law firm Latham & Watkins’ (newly-refurbished) London office. The firm’s transatlantic connections – like those of this publication – mirror the close relationship between the two continents’ debt capital markets.
Europe remains very much the junior sibling to its big brother across the Pond, however, as far as private debt is concerned. At PDI’s European roundtable discussion in London in October, some of our participants reflected wistfully on the merits of the loosely-covenanted structures that have long been a feature of the US market.
But even if the US private debt market is far further along its development trajectory than its European counterpart, how much progress has the latter made in developing a genuine alternative to traditional bank-derived debt financing? And what has that meant for people in the market on a day-to-day basis?
A diminished banking landscape
S&P’s Hugh Baxter pointed out that banks were still a substantial part of the market in Europe, despite having reduced their lending activity; he cited a Bank of England report showing that bank lending has fallen by 20 percent in the last three to four years.
“What we are seeing is a ‘squeezed middle’,” Baxter said, defining the mid-market as companies that have less than €1.5 billion in turnover and with debt requirements of less than €500 million. “That is where we see companies having a problem raising debt, despite growing interest from institutional investors investing in that space. There is demand from issuers to raise money and there is interest from investors to supply it, but bringing the two together is a problem. In Europe there is still a long way to go to get to the point where companies have access to the sort of funding options that US companies typically have.”
But why does that disconnect still exist? Information flow is a barrier, he contended. “One of the biggest issues is information sharing. Medium-sized companies have to get used to the idea that they have to divulge information and be more open. At the same time, investors need to know these medium-sized companies are willing and able to supply them with information on a continual basis so they can have an on-going awareness of any potential credit risk,” he said.
S&P has recently launched Mid-Market Evaluation (Baxter made clear it’s not a rating), based on a new scale, which it hoped would give investors an independent view of a company’s risk and help them benchmark that risk, and also help mid-market companies communicate better with investors.
Calum McPhail, head of corporate private placements at M&G Investments, welcomed that move but said it was challenging to try and overcome ingrained scepticism.
“I think there is still a cultural shift that needs to take place,” he argued. “It’s true that companies are beginning to recognise the need to develop other sources of funding. But we are trying to change a long history of very close relationships with banks, where the pricing in those relationships has been driven by the ‘relationship banking’ model – [so] companies [get] cheap debt, but the banks [provide] all the ancillary services as the compensation for that. So having to go to a market where they’re having to pay something like the true economic cost of borrowing can be a bit of a shock as to what that actually entails.”
Baxter agreed. “I think they [corporates] tend to be relatively conservative in nature. So stepping into a new world is actually a big step. There are lots of corporate treasurers out there who feel very uncomfortable about moving away from that traditional bank relationship. They know they have got to do it, but they really don’t want to.”
There are plenty of other factors that make life tough for European private debt providers. Macphail pointed out that on the investor side, US investors have a much longer history of involvement in private debt and have become comfortable with its illiquidity. “I think in Europe there is still a question mark around how investors want to price that illiquidity. Maybe they are currently placing too high a price on it, which is not helping to bring buyer and seller together.”
James Chesterman, a partner at Latham & Watkins, added that banks have traditionally played an important role in bringing borrowers and (alternative) lenders to the same table. So if you disintermediate them from the market, you need other mechanisms to allow the two to connect more easily.
Tikehau Investment Management’s Patrick Marshall chimed in, arguing that although in some cases private debt funds compete with banks, in other cases they’re viewed as valuable partners. “We have worked with banks where they’ve had a problem syndicating or there has been an issue with the credit –we are able to come in and do a mezz tranche, or in effect provide the ‘harder credit risk’ part of the transaction, to enable the ‘traditional’ banking lenders to have their transaction with a more conservative leverage ratio. Yes, we are competing against the banks for lending, but we are also working and helping them with some of their transactions,” he said.