Direct lending has taken private debt by storm. Managers who adapted quickly to the new lending environment post-crisis, and those already well equipped, are thriving in an area once dominated by banks. But in a more competitive landscape, where huge volumes of capital are being raised, newer entrants are minded to carve a niche for themselves in an effort to survive any future downturn.
Although direct lending is a global trend, Western Europe with its creditor-friendly regimes, is prime feeding ground for private debt funds. The environment left in the wake of the global financial crisis, with banks hamstrung by increased regulation, has supported dramatic growth in senior lending to private equity-backed companies by specialist intermediaries such as private debt funds or asset management firms.
The number of funds in market has increased worldwide on the back of the story. But in Europe, where the direct lending market is less developed than the US, with more fragmentation and a currency crisis to boot, an opportunity has opened up whereby the region itself is now seen as an asset class all on its own.
The popularity of senior debt provision by private debt funds has been most evident by a number of big fundraises. ICG raised €3 billion in a matter of months for its second dedicated fund, after quickly deploying its first.
According to PDI Research & Analytics, there are 479 debt funds in market at present targeting $215.2 billion. Of that, more than half, or €115.2 billion of that target, are raising origination-focused funds for – in order of size –mezzanine, senior, unitranche, venture and royalty financing strategies (see figure 1). This is unprecedented because, as records show, credit funds have typically focused on acquiring assets.
Of the $97.8 billion of capital raised over the five quarters from 1Q14 to 1Q15, $21.5 billion was explicitly for senior debt origination, significantly more than that raised for the acquisition of senior debt (see figure 2).
Daniel Sachs, chief executive officer of Proventus Capital Partners, which closed its third credit fund on €1.3 billion in December last year, thinks that direct lending will continue to grow at such a pace that it takes a bite out of high yield. He estimates that today’s roughly €95 billion in European leveraged finance volumes are recovering, following a period of much lower activity following the global financial crisis and the resulting fallout.
However, 2015’s providers of debt look very different to 2007. Then banks provided about 87 percent of financing, whereas now about two-thirds comes from non-bank sources, reducing the banks’ share to only a third. “The majority of that non-bank funding is bond funding, but direct lending is taking an increasing share and that is very likely to continue,” Sachs says.
In this growing market, new lenders are having to find a unique selling point in both their capital raising and deployment efforts. Oliver Huber, head of private debt at Golding Capital Partners, tells PDI that overall differentiation is not an easy task. “In the end it’s just capital, just money, typically in the form of senior or unitranche loans, the product is pretty standard,” says Huber.
The most obvious way to stand out is size, Huber adds. Bigger funds can attract sizeable investments and appeal to borrowers, in particular, by acting as sole term lender. “Being the only financing partner on a transaction can be helpful as speed of execution is frequently important,” says Huber.
Similarly for small funds focused on the lower-cap space, deal sourcing is less competitive and it’s possible to appeal to smaller ticket investors. Having a broad regional footprint with people in place to source deals locally is another way in which a number of European managers are selling themselves.
Having a broad offering and flexible approach and mandate for investing – providing senior to mezz and even some preferred equity – is perhaps a harder strategy to sell to investors and is an area somewhat the preserve of the bigger fund managers but if a manager can show that it can respond to the market environment and to the requirements of its counterparty, “it can give you the edge in closing deals”, Huber says.
Track record is probably the top differentiator though because most direct lending firms in Europe are investing either their first or maybe their second fund. “In the US, direct lending was around pre-financial crisis so when evaluating managers you can analyse their default and loss rates, and also how they worked with companies and sponsors during difficult times, this is more difficult to do in Europe because many fund investments are unrealised,” Tim Atkinson, a director at Meketa Investment Group says.
“Probably the best way to stand out from the crowd is if you can show you have experience of managing a portfolio successfully in a downturn and have the necessary turnaround restructuring and work-out skills, as you might need that again sometime in the future,” Huber adds.
Private debt fund managers which focus on sponsor-less transactions are certainly trying to break away from the herd. A large number of European private credit managers have private equity roots and the higher yielding leveraged finance market was where non-bank lenders first cut their credit teeth.
But while leveraged loans can offer good risk-adjusted returns, it is a small niche within the wider corporate finance needs in Europe. One market source told PDI that with the increase in the number of private lenders, managers will have to look beyond private equity-backed deals as there are not enough leveraged buyouts to go around. Indeed, for private equity firms the current environment makes for strong exits but multiples paid for assets are rising and sourcing new investments is a challenge which has hit leveraged finance deal-flow, a second market source said.
Atkinson says that asset-backed strategies are a good access point for lending to non-sponsored companies adding that “this may be an attractive way for investors to get comfortable lending to cyclical or stressed companies”.
Compared to the US, European debt funds tend to shy away from more complex lending situations. “Focus on clean, solid companies with strong cash flows is probably around 80 to 90 percent of what the market does, which means funds that do direct lending in stressed / distressed situations that are a bit more complex, although higher risk, can stand out,” Huber says.
Ultimately, success for managers relies on the deals they strike and how they cater to what borrowers want. The unitranche product contributed greatly to the rise of direct lending and continues to help funds compete with banks. Above all, the nimbleness of debt funds and their ability to make quick decisions has been their greatest strength. The reluctance of banks to fund non-investment grade smaller businesses post-crisis is directly responsible for the funds’ current foothold in mid-market lending.
The leveraged finance market, where private debt funds have sourced between 80 and 90 percent of their deals until now, has become fiercely competitive. Asset price inflation, which has increased both leverage and buyout multiples has prompted investors to question whether credit procedures could be weakening with some predicting that another stressed cycle is coming down the track.
“While the volume of deal flow is starting to pick up, it remains insufficient for the number of funds in the markets. As such, investors in this core sector of the illiquid credit markets must be cautious so as to avoid investing with managers who are unable to deploy capital quickly,” analysis from private investments advisor, StepStone noted in March.
So an increased focus on sourcing outside the private equity sphere is the natural solution to the issue of crowding in the leveraged finance arena.
“Most investors and managers lean towards sponsored deals in Europe because they believe it is safer to invest alongside a sophisticated investor with expertise and resources to provide to the business if they run into trouble. Direct lending will move more towards non-sponsored companies though, just like in the US. From a credit perspective with these investments, lenders can offset the perceived risk of not having a sponsor by pushing for more customized and lender-friendly terms as well as taking a board seat and / or equity,” Meketa’s Atkinson says.
Many managers point out that finding sponsor-less deals is challenging. One element is the negative perception of direct lenders sometimes held by corporates. The other issue is that most funds don’t have origination networks as extensive as banks. Footprint can go some way to address those issues but creative structuring may be one way funds can trump banks more easily.
One European manager which has made a lot of ground in lending to sponsor-less corporates is Stockholm-based Proventus.
Over half of its deals are for non-private equity-backed borrowers, Proventus’ Sachs, tells PDI. It is a strategy the firm has pursued since it started to invest in credit 12 years ago, with the firm first investing in mezzanine before moving up the capital structure.
Sachs’ firm has a higher proportion of sponsor-less deals because Proventus is not averse to investing in situations that involve a higher degree of complexity.
“We are also more entrepreneurial and structurally agnostic than a bank would be because our role, as we see it, is to be problem solvers and find good funding solutions for companies that cannot get funding from traditional sources,” he says.
In fact, his firm has “consciously gone into a number of stressed situations where companies have needed new funding to sort out overleverage or sub-optimal capital structures”, Sachs explains.
In order to source deals, Proventus has met with firms directly but also spent a lot of time in the market with advisors, intermediaries, banks and accountants amongst others. “This is a large part of our activity,” Sachs says, but has had the effect that the firm is now “much more visible” in the market and “people come to us increasingly”.
This reflects a trend whereby borrowers are becoming more receptive to alternative lenders: half the battle when marketing a product to them. “A lot of these financing situations have historically been done by banks. For a long time companies in Europe have been reluctant to bring in an expensive third party lender. But that has been changing since two or three years,” Huber says.
This view was affirmed at a real estate conference hosted by the Loan Market Association in May, where borrowers indicated there is a place for funds in their pool of lenders because of both their speed of execution as well as the retreat by bank lenders from some areas. Banks are no longer the one-stop shop they used to be.
Sachs believes that there isn’t any difference in returns between leveraged and sponsor-less deals but notes that the characteristics of the two types of transactions are different. “They [non-sponsored borrowers] might be funding expansion or the acquisition of a competitor or refinancing loans or bonds that are maturing, so they are slightly different types of situations,” he says. “Because there has been an inflow of capital into this broader direct lending market, the kind of situations that are more transparent, more plain vanilla, easier to understand, and structure and invest in, have come under a lot of pressure so the risk adjusted returns in those situations have come down quite a bit. In more complex situations that require more work, both in sourcing and structuring, the pricing has been more stable.”
Huber agrees: “From a risk perspective, depending on the situation, [non-sponsored deals] can be even more advantageous than going into a highly levered sponsored transaction. However, it typically requires more work in sourcing, analysing and executing a deal.”
Though there are a different set of concerns to consider when looking at this part of the market, the StepStone research highlights: “Critical elements of sponsor-less lending are the form and identity of the equity, which give comfort to the holders of senior loans in the event of default.” Thus, the firm argues, commitments in this space require substantial due diligence on the fund manager’s origination, network and underwriting techniques.
As direct lending in Europe evolves and competition becomes intense in certain areas, the key to survival will be to separate from the pack. Going where others won’t has already paid off for some managers. Apollo Global Management in their first quarter results said that establishing platforms to invest into even more opportunistic and idiosyncratic deals is a main focus for the global firm. New entrants can observe and learn from leaders in the field, before beating their own path.
With the amount of capital flooding into the space, deal flow will be crucial, and key to grabbing it will be offering strong solutions for borrowers.
Some worry that pressure to deploy capital in a competitive market will lead to deterioration in credit ahead of the next distressed cycle. Diversifying the pool of borrowers will allow new private debt entrants to both gain an edge and avoid the dangers of groupthink in a crowded market.
That in turn, is key to those all-important strong returns.