Alternative lenders are on the rise, but deal origination is a major potential stumbling block as private lenders continue their march onwards and upwards.
In particular, the mid-market funding gap – upon which so many private debt strategies are premised – is closing fast, according to market sources and recent reports.
In January, for example, ratings agency Standard & Poor’s published a survey on the expanding array of borrowing options open to European mid-market companies, including the nascent European private placement market, private debt funds and domestic bond exchange platforms. And banks, too, have been competing in the higher end of the mid-market.
S&P analyst Taron Wade says that while financing options for mid-market borrowers have expanded considerably beyond the bank lending that dominates Europe, one challenge (or opportunity, depending on your view) is that many borrowers remain unfamiliar with the various options available.
In the US, though the precise circumstances are different, the effect is the same, says Ted Koenig, president and chief executive of Monroe Capital, a mid-market lender based in Chicago that has been in business for over 15 years.
“I think that the mid-market has plenty of financing options today, between the regulated bank market, and the non-bank market,” he says, noting he’d be hesitant as a new entrant in today’s mid-market finance business without the backing of a broad platform like Monroe’s, which includes 20 origination professionals across eight US offices.
There is plen ty of liquidity in the market, Koenig says, adding that just getting a deal through the door isn’t enough unless you’re content with below par returns.
Finding the right on-the-ground talent is key, says UK-based Symon Drake-Brockman, managing partner at Pemberton. He previously helped build up Royal Bank of Scotland’s capital markets capabilities between 2000 and 2005 before becoming its global head of debt markets, and now at Pemberton has helped build up its team.
The firm, 40 percent owned by insurer Legal & General, made a number of key changes to its team over the last six months including hiring ex-Royal Bank of Scotland banker Thomas Duetoft to head up origination. John Doyle, formerly head of leveraged finance at Seimens Bank, was brought in to head UK and Ireland. Most recently, Jürgen Breuer joined from German lender Dresdner to lead the firm’s push into the German, Swiss and Austrian markets. While at Dresdner, Breuer built out the leveraged finance business to become the most active house in Germany, before he moved on to do the same at WestLB.
Private debt funds have their roots in private equity; many were in fact established as separate credit arms within private equity houses. So it’s unsurprising that their focus is often on lending to private equity portfolio companies, which have the added benefits of extra yield deriving from higher leverage multiples, as well as often higher standards of corporate governance.
But private equity is a finite world and with more and more private credit funds launching, the competition is heating up. Both European and US leveraged finance markets have seen yields fall and covenants loosen.
In Europe, the numbers make it pretty clear that deal origination will be a key factor in separating successful firms from the unsuccessful. Of the roughly €160 billion leveraged loan market, around €120 billion is for fresh deals (i.e. not refinancing). And of that €120 billion, banks last year absorbed €75 billion, CLOs took up €15 billion, which left €30 billion to non-bank lenders, says Drake-Brockman.
Just shy of $50 billion in capital was raised by funds focused on corporate credit last year, according to PDI data. Just over $15 billion – or €13 billion – was for European strategies. And those figures only count funds that reached final close, it does not include commitments already being deployed following first or second closes.
No wonder leveraged loan terms are loosening.
Without a substantial pull-back by banks, there is not room at the leveraged loan table for every fund manager.
In contrast, the mid-market corporate financing market in Europe totals around $2 trillion.
And that is why direct lending funds must make a push to truly go direct and seek out the family-owned and unsponsored private businesses that are in need of capital.
That’s certainly Pemberton’s plan. “There is still an ongoing shortage of financing for certain companies in Europe but the issue is that that financing gap is not in the sponsored community, the financing gap is in the true, regional, corporate [space] across Europe,” Drake-Brockman explains.
For those who can’t or won’t look beyond PE portfolio companies, some form of specialisation or differentiation is necessary.
US-based Star Mountain Capital aims to access borrowers that are under-served by lenders by taking a hybrid fund of funds and co-investment approach. The firm invests in a large number of lower mid-market credit funds across the US. Most of these credit providers are small and focused on sourcing small, local deals in the region where they are based.
As well as making its LP commitment(s), Star Mountain co-invests with these funds. If the credit fund can’t manage the full exposure but doesn’t want to bring in a competitor, SMC will come on board separately to support the deal.
Ryan McGovern, managing director and investment committee member at Star Mountain, calls it a ‘hub-and-spoke’ model providing access to opportunities at the smaller end of the market.
“We think it’s a more attractive part of the market because you can have second lien/mezzanine debt positions within the capital structure and yet be at lower leverage levels than even first lien senior in the larger market.” he says. “You have the ability to achieve better returns at lower leverage.”
He agrees that sourcing those deals is labour intensive and that is why, he says, SMC’s network approach works.
FINDING A FOOTHOLD
Alternative lenders in both the US and European markets have shown that it is possible to grow and gain market share. But the private debt sector has not fully proven itself yet – and originating strong and sustainable dealflow for a wide variety of borrowers will be the test.
Some funds will have to overcome perception issues around ownership, notes Drake-Brockman: “People are very clear with banks: banks don’t want to own companies. People have concerns that some of the [debt] funds are quite happy to own companies because they can make large returns.”
In Europe, many borrowers are still unfamiliar with even the strongest credit fund brands, says Drake-Brockman. Funds need to demonstrate consistency and reliability, he says.
Koenig agrees. “Longevity throughout the cycles creates a lot of reliability for counter-parties,” he adds.
For those without market tenure, specialising or building out into the larger, non-sponsored corporate world may be the way forward. Otherwise, paltry returns and a short life-cycle await.
DIRECT LENDING – LACKING DEFINITION
We hate to say it, but direct lending is still looking a bit flabby around the waist. The phrase was bandied about by all kinds of people last year when describing their credit strategy. And if you’ve been to too many parties and had a few too many nice dinners, definition is the first thing to go.
The strategy was popular with investors – a large number of funds branded as direct lending were launched or closed last year. And there are very solid reasons behind its popularity; making loans to companies under-served by the banking market ticks boxes in terms of asset/liability match, supporting the real economy as well as earning everyone involved political brownie points.
But more than one person in the market has pointed out that the label has not been clearly defined, and this has been exploited by some seeking to capitalise on the fuzzy understanding of what direct lending really is.
PDI was somewhat horrified to learn that someone in the market was selling a fund targeting investments in the syndicated leveraged loan market as a direct lending fund. Buying into large primary deals arranged and sold down by bank lenders is not direct lending. And yet the term has been applied to so many different things, that it was felt the general leveraged finance market could be labelled direct lending.
So what is direct lending?
Sourcing a borrower directly – not via a syndicated bank deal. That is direct lending. And PDI would go further. Loans for private equity portfolio businesses should not be counted under the definition either. There will always be some within a private debt fund’s loan book, higher leverage means higher returns and those drive investment, but the pool of private equity-backed businesses is finite.
If private lenders really want to achieve scale, they will have to move beyond the PE-backed paddling pool of credit investment. Non-sponsor backed companies account for a far higher percentage of corporates and a commensurately larger slice of the €2 trillion finance market.
Private credit strategies, naturally enough, evolved in the leveraged finance market. But that’s no reason to dilute something that should be carved out as distinct. Those not interested in lending to non-sponsor borrowers have other ways to describe themselves. Direct lending should be the preserve of the ambitious funds seeking to do more.