Direct lending is now a permanent feature of the European market: the volumes of deal done by direct lending funds increased by 120 percent year-on-year and it is estimated there are now around 42 active direct lending funds up from 18 in 2012, and an estimated 81 new funds out in the market raising around £50 billion, according to RBS. Why has this asset class grown so explosively, and is this growth led by demand from corporates for liquidity, or institutional investors looking for alternative sources of higher yield? Does it offer investors a long-term source of portfolio diversification?
WHAT’S CHANGED IN 2014?
In Europe, bank deleveraging and the overall reduced levels of bank lending since the global financial crisis is a recurring theme: in March 2014, a survey by the European Central Bank (ECB) showed that mid-market corporates continued to report a reduced supply of bank loans for the fifth consecutive year. The fact that Europe’s economy has been so heavily reliant on bank funding, especially compared to the US (see diagram 1), has meant that there was no established capital market solution that was ready and able to provide the necessary liquidity for mid-market corporates. Instead, since 2012 we have seen the rise in asset managers jumping in to fill the liquidity gap by launching direct lending funds, and this trend has continued strongly in 2014.
The emergence of direct lending funds in Europe is not wholly unexpected as it mirrors the development in US financing markets, and it has been supported by the efforts of European national governments who are looking to promote alternative sources of debt capital for mid-market corporates, for instance the UK’s Business Finance Partnership initiative. It is clear too that it is not only supply-side dislocation that is driving this market opportunity, as there appear to be many mid-market companies that actively want to diversify their funding away from an over-reliance on a small number of banks and who see the new breed of direct lending funds as good long term-financing partners. In the first quarter of 2014, there was 120 percent growth year-on-year in transactions completed by private debt funds, according to Deloitte. The UK is the largest market for private debt funds, with 47 percent of the transactions, although activity levels in France and Germany in particular are now growing at a faster rate than in the UK as borrowers in these markets become aware of the alternative sources of capital.
DIRECT LENDING AND CORPORATES
Asset managers act as longer-term business partners to corporates, supporting good businesses with long-term financing solutions that are structured in a more tailored way for each borrower to better help these companies achieve their objectives. For mid-market companies, this more flexible partnership approach is proving popular. A recent report from Grant Thornton entitled ‘Capital for Commerce’ found that of the corporates they interviewed, 61 percent had used a non-bank lender, and of this group 49 percent had used direct lending funds. Of those interviewed, 79 percent viewed non-bank lenders positively or very positively, so among corporates this style of financing is established, positive and gaining popularity. In addition, the more established direct lending funds also have deep pockets, which means that they can often support multiple funding rounds by the same borrower, thereby providing management with more certainty and long-term support for their growth plans.
Institutional investors clearly favour the direct lending strategy, as the risk-adjusted returns on offer make these one of the most attractive private debt strategies. In Preqin’s Investor Survey on private debt, published in July 2014, 78 percent of respondents indicated a preference for direct lending – ahead of mezzanine with 61 percent, distressed debt (59 percent), and real estate debt (43 percent). From ICG’s perspective, investor support has been a key element in driving growth for direct lending, as the ability to raise large funds has enabled fund managers to write bigger loans, which in turn has made the direct lending funds more attractive partners for borrowers to work with.
Investors are looking for ways to drive additional yield from their fixed income portfolios. So direct lending funds like ICG’s that offer access to a portfolio of mid-market corporate senior secured loans, with an overall ‘sleep at night’ level of risk but with signficant return premiums available to compensate for the illiquidity of the underlying loans, are attractive. In the Preqin survey, 69 percent of institutional debt investors expressed a preference for senior debt structures. Our most recent direct lending fund, which is focused on building a portfolio of directly originated senior secured loans, closed 70 percent over the original target size on €1.7 billion and, notwithstanding the enlarged size, we have been able to successfully deploy capital within two years.
A key driver to investor demand is risk tolerance and allocation. Direct lending has fallen sharply into focus because it is one of the most straightforward private debt strategies for investment committees to understand and analyse, and because it often falls favourably at the less risky end of the scale. Portfolio allocation around private debt is still evolving, some allocate from a fixed income bucket, some from alternatives, private equity or even a hedge fund bucket. There is an increasing trend particularly from large pension funds to have an allocation specifically to private debt, which is particularly true of US schemes where the practise is more established.
With so many new funds launching it is important for clear fund differentiation of strategies. As explained above, ICG’s approach to direct lending targets more conservative senior lending opportunities where we use our local origination network across Europe to find good, profitable and cash-generative mid-market companies that we can build long-term relationships with. For ICG it is not about distressed lending or opportunities of last resort, but long-term capital partnership and helping mainstream, mid-marktet companies to achieve their objectives. Not all asset managers have this approach, and some new funds that have launched this year are calling themselves direct lending funds but are focused more on providing higher-risk debt financing to more marginal or finanically stressed companies. This is not lost on investors or corporates, and has probably led some commentators to view direct lending more negatively and to use more emotive terms such as ‘shadow banking’ to describe, which suggests an industry operating in the most highly leveraged and opaque echelons of lending. This lack of clarity as to the differences in direct lending strategies – mainstream, long-term capital partnership versus opportunistic capital of last resort – is not very helpful for the development of the market, nor is it helping borrowers who are looking for an alternative source of liquidity to understand the opportunity of working with direct lending funds.
As bank lending in Europe continues to contract, the number and range of direct lending strategies will continue to grow. The mid-markets are most impacted by the dearth of bank lending, and asset managers are fulfilling a critical role in providing them with lending liquidity. This is a quantum shift and a structural change in Europe’s capital markets, presenting a new opportunity for institutional investors to diversify their portfolios and achieve solid risk-adjusted returns. The positive momentum among both corporates and investors is encouraging. Given the fact that the IMF believes there is €2.8 trillion of debt capital required by non-financial corporates in Europe over the next four years, we are confident that quality direct lending funds will continue to be busy for a long time to come.