As active investors across the global private debt spectrum, our team at Babson is currently finding attractive value in corporate private placements, infrastructure debt and, the subject of this article, the direct lending market.
The direct lending market is global in nature, but regional differences are critical to understand as they present opportunities for skilled managers. At a high level, the factors that impact the relative attractiveness of private loans across the US, Europe and the developed jurisdictions of Asia-Pacific are effectively the same. M&A activity is widely seen as the most significant driver as it directly impacts demand for financing solutions. Regulation also plays a key role; increased capital constraints on banks have restricted credit supply, creating opportunities for non-bank institutional lenders like Babson.
As these dynamics ebb and flow in each region, they impact the pricing and structural terms for private loan transactions. This in turn drives the relative attractiveness of investments in each region. Over time, the changing dynamics create opportunities for managers with a local presence in each market to ‘pivot’ to the region where the most attractive relative value opportunities lie.
When considering a global strategy, it’s important to note the key differences between each region.
The US is the most developed market in the world and offers the largest opportunity set from which to accumulate a diversified private credit portfolio. The Dodd-Frank Act, requiring more robust capital standards – consistent with Basel III – has spurred regulators to issue tighter lending guidelines. These new regulatory standards are impacting supply/demand dynamics and creating an increasingly attractive opportunity for investors. For instance, General Electric, which became subject to big bank-like regulation in the wake of the financial crisis, divested its private equity lending business that for decades was a dominant provider of credit to US middle-market businesses. At the same time that the supply of capital is being restricted, the demand for it is increasing: US mid-market M&A activity is still well below pre-financial crisis levels but has been rising, a trend we expect to continue.
The European market, though much smaller, is growing rapidly as capital requirements increasingly limit banks’ lending activity, Basel III specifically. The number of new private lenders into the market has increased in an attempt to capitalize on the opportunity. But given that the direct lending model is built upon long-standing relationships between lenders and sponsors, those lenders with established relationships, long track records and local knowledge are likely to be better positioned to fill the financing void.
The private credit markets in Australia / New Zealand and developed Asia are more difficult to dimension but can offer compelling opportunities for experienced lenders with local knowledge and relationships. Most medium and even large issuers in the region do not have access to the more developed US and European credit markets, and regional banking options are limited. Supply/demand dynamics, particularly in Australia and New Zealand have created opportunities to lend to strong companies on attractive terms.
The relative attractiveness of direct lending investment opportunities shifts, reflecting regional supply and demand dynamics. For example, US private credit spreads remained relatively tight through mid-2014, while the pricing of risk was much more attractive in Europe. Spreads in the US then widened in the latter part of 2014 and have remained at attractive levels throughout 2015. Based on Babson’s market observations, US ‘all-in’ effective spreads are now on par with Europe at approximately 600 basis points (bps) for senior debt and 750bps to 900bps for unitranche debt.
While pricing in these markets is comparable today, there are structural differences. For instance, while LIBOR floors are normal features in both US and European transactions, they are commonly set at 100bps in the US, whereas in Europe, LIBOR floors range between zero and 75bps. European issuers tend to be larger on average than those in the US and total leverage levels are typically more conservative. These regional differences present relative value opportunities for skilled managers.
Although spreads in the Australia / New Zealand and developed Asia markets are currently tighter compared to the US and Europe, issuers typically are larger and have more conservative credit structures. We are seeing opportunities to source attractive loans in these markets, where there is a diverse base of financially stable companies across a wide variety of sectors.
Global managers with a local presence in the markets where they invest are well-positioned to access a broad opportunity set of deals. Private equity sponsors typically transact with lenders with whom they have experience and that have a proven track record in the market. Developing a strong track record requires many years of experience, and lenders without strong relationships may miss out on the most attractive investment opportunities.
It is also important that managers possess specialized experience in underwriting loans to mid-market companies, as the due diligence process is much more intimate than in the broadly syndicated capital markets. For instance, syndicated loan and bond investors typically receive an offering memorandum prepared by an agent or an underwriter and participate in large ballroom presentations or conference calls. For private credit investors, understanding risk is the result of rigorous due diligence similar to – and usually alongside – a private equity sponsor.
As part of the due diligence process, lenders like Babson directly participate in facility tours and on-site meetings with management to enhance their understanding of business operations and evaluate a management team’s strategy and ability to execute. Once a company’s credit risks are fully understood, private credit managers must also possess the knowledge to understand and negotiate structural protections, like maintenance financial covenants, that can help mitigate risk.
Finally, it is key to partner with managers who have systems in place to closely monitor their investments and experience investing through multiple economic cycles. Private loans are not liquid; there are no secondary prices to monitor, and there is limited to no ability to trade out of a position. This makes monitoring a particularly important component to mitigating the risk of loss.
As investors look to the direct lending market as a way to enhance returns and diversify their portfolios, we believe a global approach is critical. As market dynamics shift from region to region, a global perspective – combined with a local presence – can help managers source the most attractive value on behalf of investors.