Direct Lending: EQT Credit on why a deal needs a home

Why did EQT Credit enter the direct lending market in 2005?
Andrew Konopelski:
When we started in mid-2008, the vision, the ultimate objective, which has taken six or so years to achieve, [was to have] a suite of funds so that there is a natural home for any attractive deals we found. That [allows] you to really take a relative risk view across the whole spectrum and to price risk appropriately. So we started with credit opportunities and at the other end of the barbell with senior debt managed accounts. 

There was a fairly obvious gap in the middle and we came across more and more deals as we were out sourcing for the opposite ends of the barbell that we thought would fit quite neatly, that were good risk-reward but didn’t have a natural home [with us]. We are certainly not the first to direct lending, but we wanted to make sure, both for ourselves and the LPs, that the market had permanence. I don’t think that was clear for a long time.

And we wanted to make sure that we had the right platform, the right people in place that when we raised the money, we were ready to hit the ground running, rather than raise the money then figure out how to deploy it.

We find that the original thesis – if you find a good deal, it has a natural home – is quite powerful.

How do the sponsors you lend to feel about borrowing from the credit arm of another private equity firm?
Paul Johnson: I think we have a halo effect from being part of EQT. Geography is particularly important. Our pipeline is overweight continental Europe and that’s a straight reflection of [the fact that] we’re not starting from scratch, we’re starting from being part of EQT. It’s no coincidence that our two most recent deals were in Germany and Finland.

Sponsors have welcomed the idea of us using EQT’s network of independent industrial advisors to be responsive because we can use our local network to understand businesses quicker. One of the reasons this market has grown so much is not whether banks are willing to lend or not – it’s the flexibility, the speed with which institutional lenders can respond.

Tell me about what you did in 2015 as you got up and running?
PJ: We built the pipeline pre-summer and have been deploying since just before summer. We’ve completed four deals. In terms of pipeline, the bigger challenge is being selective to allocate resources to the deals you really want to do. There has been a massive volume of introductions, literally hundreds of potential opportunities.

AK: It’s fair to say the pipeline has been well in excess of what we anticipated.

PJ: It’s not a question of will there be growth in 2016, it’s a question of how much growth. We think four to six deals per year is reasonable enough to be selective and yet to deploy sensibly for investors. We’re slightly ahead of that and we could be a lot further ahead of that if we wanted to be, but selectivity is the name of the game in this market.

Ralph Betz: What we see is quite a nice spread across geographies in terms of the sourcing. In a ballpark you could say that about a third is in the UK, about a third is in the DACHs region and about a third is across other jurisdictions with a strong focus on Benelux and the Nordics.

So is the fund deliberately more Europe-focused?
AK: I think there’s a bit less competition. The UK market is pretty well trafficked.

PJ: It’s not easy to crack Europe for any credit team largely based in London. We’ve got an advantage because we’ve got 150-200 people on the ground in Europe already.

So do the PE guys give you a call if they see an opportunity that’s a better credit deal?
AK:
We don’t compete with them because I don’t think any sponsor would bring us into the tent with them if our guys were active bidders, nor would we ask them to. And conversely, to Paul’s point, the network is valuable from a diligence standpoint so to compete against EQT Equity would mean we wouldn’t have full access to the network. We’re very open with other sponsors that we’re not going to support them if EQT is in the bidding process.

What are the differences within the various jurisdictions of Europe?
RB:
The UK and Germany have strong pipelines. But you have to look at the conversion rate, the UK has a stronger conversion rate than Germany. We are less active in France and Spain at the moment but it is something that we see more of in the future.

AK: In the UK, when a sponsor comes with a deal, they generally know what they want. Whereas on the continent there’s – especially in places like Benelux – still a bit of the art of the possible. So they’ll talk to direct lenders but they’ll also talk to the banks. There’s an education and an exploration process going on.

PJ: We had an example [of a] financial sponsor which had a financing partner in London who wanted to proceed down the unitranche route whereas the local deal team, outside the UK, wanted to use the banks. So sometimes they’re learning themselves as an institution. The understanding and appreciation of the benefits of a non-bank lending alternative [are] coming out – dare I say – from the UK across Europe.

Which is why I think it’s not a question of whether there will be growth, it’s a question of how much. 2016 is going to be more than double the volumes of 2015 outside the UK, without a doubt.

So 2016 looks strong but there are headwinds. What’s your view as a lender entering the New Year?
AK: You need to pick your portfolio well because you need to be aware that Europe is not in a 2-3 percent GDP growth environment where we’re all going up for the next four to five years. Cycles do occur in credit. 

But growth is not essential to credit – borrowers just need to be able to pay their bills.
AK: That’s right, but not every credit that we see has that profile. In this market, where there’s a lot of money available to lend and a lot of private equity money to invest, you’re seeing leverage levels put on businesses that shouldn’t be. And then there is leverage being put on less cyclical companies that can support it through the cycle: where you can do downside analysis [and] see that they can pay their bills. It doesn’t change your business, you just need to be more cautious and do your credit work appropriately.

RB: These uncertainties also hopefully lead to the banks being more cautious and putting less leverage on transactions, which would help increase opportunities from a direct lending perspective because we can be much more flexible in the way we deploy the capital to certain assets. We don’t have a tick-box exercise where we say we are in a difficult environment and can’t lend at the moment.