Feature: A deal for every fund, or a fund for every deal?

Originate, originate, originate used to be the mantra of the European direct lending market. Offering alternative debt solutions for small- to medium-sized enterprises (SMEs) since 2010, direct lending funds had capital, but lacked the sophisticated origination network of their high street bank predecessors.

Fast forward to 2015, direct lending funds have become part of the credit solutions lexicon, and instead flexibility is key.

In this more mature market, direct lending funds that can offer diversified products are emerging as the winners. Financiers able to move easily between geographies and with access to different credit through the capital structure are closing the decent deals.

“Overall we see the market moving more towards people with maximum flexibility or managers with separate ‘pots’ to allow different pockets of money to be used depending on the situation,” said a direct lending fund manager. “If you are a single direct lending fund, I think life will be hard.”

Mezzanine or alternative capital houses raising small direct lending funds could be the ones to lose out on offering flexibility, argue a handful of asset managers. The volume of direct lending capital raised by mezzanine lenders in particular has provided the cornerstone of direct lending, as demand for pure mezzanine in large cap deals has dwindled in favour of cheaper all-senior or senior and second lien capital structures.

Recent diversifications into direct lending include Mezzvest, an asset manager historically focused on mezzanine which has raised around €100 million for a direct lending strategy from an investor, as reported by PDI, and alternative investment manager CVC Credit Partners, which began fundraising last year for its direct lending offering with a target of €600 million.

Alternative credit solution provider Permira Debt Managers is targeting €800 million for its direct lending fund which was set to close within the next few weeks at the time of publication. While mezzanine provider Crescent Capital operates a European Specialty Lending strategy which recently closed a unitranche financing backing The Carlyle Group’s acquisition of Spanish IT group Televent Global Services.

Adding a direct lending appendage to an existing credit platform maximises market footprint, runs the logic. However, credit managers will need to be careful that their existing debt products do not get in the way of the flexibility of their new direct lending offering, warn asset managers. 

One way to do this is for direct lending funds to distance themselves from their parent company’s pool of sponsor-backed deals. As the large part of alternative credit solutions providers were tagged onto private equity houses, sponsor-backed transactions were the natural starting point for their senior and mezzanine solutions. Existing origination strategies, as well as a tendency to prefer sponsor-backed deals inevitably led to a similar approach being applied to direct lending fund investments.

“Now, direct lending funds need to be looking outside of sponsor-backed transactions in order to evolve with the market,” said the second investment manager. Considering off-market transactions, deals involving equity, and those without a sponsor will be key to maintaining a competitive edge in direct lending, said sources.

Some even argue that the true definition of direct lending is providing credit to sponsorless borrowers. Intermediate Capital Group positioned its mezzanine fund towards off-market deals when sponsor-led mezzanine financing dried up, allowing it to thrive since the financial crisis.

“The key is to maintain separate strategies in separate funds, be that senior or mezzanine, or direct lending,” said the second asset manager. 

The unitranche debt instrument has historically been the bread-and-butter of direct lending funds. However, the flexibility to be able to invest across the capital structure can give one direct lending fund the edge over another when pitching a credit solution to a borrower. 

“That flexibility is very helpful in winning deals,” explained an asset manager whose direct lending fund can encompass payment-in-kind credit solutions (PIK), mezzanine and unitranche through to senior debt.

Whereas some direct lending funds have direct access to different debt solutions from within the same fund, a so-called ‘blended’ solution, others can only access that capital by working with the existing mezzanine fund, or special situations fund of their parent asset manager – the ‘product’ offering. 

This can throw up hurdles, as most asset managers with different funds under one umbrella will have rules around investing in the same credit, explained a third asset manager. 

“A mezz product and a direct lending product cannot enter into the same credit because they represent different investors that are comfortable with different levels of risk,” he went on. “Large LPs such as institutional investors and sprawling family offices want to hear a clear strategy and to know that it will be delivered. Direct lending funds, for example, promise returns of between seven and 11 percent, mezzanine from 11 to 12 percent.”

The third asset manager concluded: “These rules will either suggest not to do it at all, or, to do it but to implement limits, for example, control of the mezzanine debt but not of the more senior debt.”

To avoid ‘cannibalising’ the existing mezzanine or senior fund via direct lending activities, it is important to draw strong distinctions between the credits that they play in. Either to reserve the existing mezzanine product for hefty slices in large-cap LBO financings, or, as in the case of Intermediate Capital Group, to ensure the mezzanine product is an instrument for off-market transactions, differing to the typical unitranche product offering in the direct lending space. 

A direct lending fund that can offer a ‘blended’ solution can offer different debt products to its borrower without these restrictions. Certain direct lending funds in the market have been raised to invest in senior, unitranche, mezzanine, and PIK all through the same fund. Some examples of these funds include Bluebay Asset Management’s direct lending fund, and Ares Management’s European direct lending offering.

Flexibility to carry out sponsorless transactions and to offer a variety of financing solutions allow a direct lending fund to remain competitive without resorting to high leverage multiples and low pricing seen in the large-cap senior fund space since 2011.

For example, unitranche sizes are creeping up EUR 200m at the highest, and turns of 5x at pricing of 675 basis points to 700 basis points on a pure unitranche, according to a fourth fund manager.

The most flexible set-ups can enable direct lending funds to be completely agnostic about deals. They can originate directly or participate in someone else’s deal, underwrite a financing or bring in partners for part of the transaction afterwards – thereby opening up new origination opportunities and reducing price competition.

“Players need multiple hats to be able to navigate these waters,” commented a fifth fund manager.

Now that the direct lending market is maturing, participants must move away from the traditional model – a sponsor in need of unitranche financing – in order to remain competitive.

And the fact that some direct lending funds have already been spreading their wings into restructured deals in need of a senior debt piece shows that for some, the wind has already changed.