Europe’s private equity market has long been troubled by tension between the sponsors that borrow money and the banks that lend it.
Sponsors in the mid- and lower midmarket – making acquisitions of between €10 million and anything up to €500 million – often want to expand portfolio companies aggressively because the maximum upside of a successful private equity investment is very high indeed.
For the banks providing the leverage to juice equity returns, however, the maximum upside is simply to get their money back with a reasonable rate of interest on top. This explains their historically conservative approach to lending, though they tend to give borrowers more flexibility at the top end of the mid-market. The relationship is, perhaps, akin to that of a wealthy father happy to lend his Ferrari to his son who is learning to drive, but averse to letting him test the full capacity of its engine. The son wants to test its ability to accelerate from zero to 60mph in three seconds; the father just wants the car back in the garage, without any bumps, at the agreed time.
Sponsors, and their advisors, like the recent surge of direct lending in Europe because it helps to resolve this tension. Direct lenders have often been prepared to fund riskier deals and on more flexible terms than banks will accept.
This comes, however, at a price: a sponsor who uses a direct lender should expect to pay more. The conundrum is summarised neatly by David Parker, partner at Marlborough Partners, a London-based debt advisory firm. “If a business is a very good credit and has a high EBITDA multiple, and its sponsor isn’t looking for amazing flexibility, the sponsor will go with a bank deal,” says Parker. “But if the business has a wrinkle – and even a normal business has a wrinkle – the sponsor might well go with the direct lending deal.”
Direct lending has grown rapidly in Europe in recent years. Much of the initial impetus came from bank deleveraging: the trend for banks to cut back on lending to meet strict new capital rules. The large supply of US money, from direct lenders seeking better returns across the Atlantic than were available in the crowded US market, also provided a powerful fillip.
These factors created an opening for direct lending, which was prised wider by alternative lenders offering a new, much more flexible way of doing business.
As a result, “direct lenders have been through a tremendous evolution in a very short time”, says Daniel Gendron, partner and leveraged finance specialist at Linklaters, the law firm headquartered in London. “Direct lending is now considered a credible alternative, and in many cases a desirable alternative, for almost any midmarket deal.”
“Nowadays, it’s an exception when they don’t feature,” says Chris Lowe, a Londonbased partner in accounting firm EY’s corporate finance, capital and debt advisory team. “It doesn’t mean they’re the end solution, but it’s rare when they’re not considered.”
Parker of Marlborough Partners estimates that five years ago only about 1 percent of the number of loans to sponsors were made by direct lenders – but this rose to 10 percent two years ago, and now “maybe 25 or 30 percent”.
A crucial factor in this growth has been direct lenders’ reputation for offering more flexible terms, including looser covenants and unconventional repayment options. In many cases, banks will not accept these terms for mid-market deals at any price.
“Banks have to live within credit approval processes, so there are some routes they just can’t go down,” says Parker.
Lowe cites casual dining as an example of the sort of business that could benefit from the specific instances of flexibility which direct lenders to mid-market businesses are much more likely to agree than banks: deals where the interest is paid not during the life of the loan, but at the end – giving more cash for the business to expand.
A casual restaurant chain could, he says, accelerate earnings by refurbishing existing stores and rolling out new ones. Lowe thinks the same principle could also work for retail. This would naturally cost extra, says Lowe: the sponsor might be able to borrow at only Libor plus 4 percent from a bank, but might have to pay Libor plus 6.5 percent to borrow from a direct lender with a more flexible bullet repayment structure versus an amortising bank loan.
However, “it may be worth paying the extra 2.5 percent for flexibility, and using that to drive the equity story harder, to end up with a stronger equity position because the business has more free cashflow”, adds Lowe.
Matthew Sabben-Clare, a London-based member of the financing team at Cinven, the European private equity firm, makes a more general, cross-sectoral point. He recalls that many sponsors who borrowed heavily in 2005-7 were forced to seek covenant amendments because of the European economic slump. His conclusion: “It’s clear that we need to maximise covenant headroom and, where possible, take covenant-lite debt.”
When it comes to “headroom”, he seeks covenants loose enough to avoid being breached in the case of an unexpected business downturn. This looseness might need to apply to a variety of terms, such as the net debt to EBITDA ratio. And covenant- lite debt might excludes this ratio altogether.
Thus far, however, fully covenant-lite packages are rare in the European midmarket. Though market observers note that cov-loose structures became increasingly common in 2015.
Parker of Marlborough Partners lists other forms of flexibility often offered by direct lenders, such as the freedom to take on more debt and the ability to take dividend payments out of the business immediately.
Lawyers and debt advisors say they are also often willing to accept higher leverage.
“For the right deals, direct lenders are also able to offer unitranche solutions that on average will provide borrowers with anywhere from a half to a full extra turn of leverage above what the senior bank market is willing to do,” says Linklaters’ Gendron.
An extra turn of leverage would extend a net debt to EBITDA ratio from 5x to 6x, for example. Unitranche debt, the most common instrument deployed by direct lenders, combines senior and subordinated debt into a single loan.
Some observers say speed is important, too.
“One of the great selling points of direct lenders is that they’re nimble,” says Gendron. The speed advantage lies largely in the fact that they are often prepared to make the entire loan, whereas banks are increasingly likely to syndicate deals over €50 million. Bank hold sizes have been falling and syndication carries with is an inevitable delay as more parties are brought into the deal.
This speed advantage is being sharpened by the fact that direct lenders are extending bigger loans. “Five years ago direct lenders were writing €30 million cheques – they were no different from the banks, by and large. Now it is the norm for them to do €50 million-€100 million, and there are some that can write €300 million or €400 million,” says Parker.
Direct lenders can be nimble indeed. “We have seen deals go from standing start to funded deal in under three weeks,” says Gendron.
He acknowledges that the banks can be quick too, but argues that because of their internal processes and need to take market soundings, “direct lenders will, on an average day for an average deal, be quicker to execute than most banks”.
The financial liberality offered by direct lenders carries a cost, however. Gendron says that direct lenders tend to require interest rates on average 1-3 percentage points higher for unitranche loans than for banks making senior loans – though he estimates that this has narrowed from a 5-7 percentage point premium two or three years ago. This is broadly in line with the 2.5 percentage point differential for a flexible direct lender deal cited by Lowe of EY.
Because of this cost premium, banks tend to dominate plain vanilla deals, where they are happy to lend at low rates because leverage is not excessive, the covenant terms are strict and both principal and interest are paid regularly over the life of the loan.
It is not only the pricing that has become more similar – direct lenders and banks are starting to resemble each other in other ways too.
“Banks are becoming more prone to offer light covenants for larger or stronger deals,” says Sabben-Clare. “The banks have to some extent been shaken up, and this has increased their competitiveness.”
This is echoed by Keith Breslauer, managing director of Patron Capital, a pan- European private equity firm focusing on companies backed by real estate assets: “The non-banks have, compared to three or four years ago, become a true competitive force, but they’ve inspired the banks to get back into business.”
Because of this interplay, Robin Harvey, partner and co-head of private equity at Allen & Overy, the law firm headquartered in London, says borrowers should be open-minded. He notes that sponsors might find their preferred balance for a deal from a direct lender, at a bank, or at a combination of the two.
But aside from the hard issues of pricing and terms, the soft issue of human relationships matters too, say observers.
“When selecting a debt provider for a deal, it’s important that we’re comfortable with the relationship,” says Sabben-Clare. “We like people who are invested, on the debt side, in a number of our businesses. This means we know they are interested in maintaining a constructive relationship with us across the board” – showing patience with the sponsor if a portfolio company runs into trouble, and showing support if a portfolio company is doing well and needs more money for acquisitions.
Until recently, the relationship factor presented an advantage for the banks: they were the incumbents and had strong ties with sponsors. Now, however, the banks are beginning to lose this edge. In the words of Gendron: “Sponsor attitudes have changed greatly. A number have very good and increasingly close relationships with direct lenders.”
This is echoed by Harvey: “The successful funds build relationships with sponsors, who grow comfortable with them after seeing that the funds can deliver.”
Direct lenders have also nurtured strong relationships with private debt advisory businesses – one of the most important origination sources for European mid-market loans.
The debt advisors often advocate more aggressive financial engineering than sponsors might attempt if left to their own devices – and this will often necessitate deals with direct lenders.
“Some of the good debt advisors have been instrumental in allowing direct lenders to take a bigger share of the market because the advisors will run a number of potential capital structures at the beginning of deals,” says Gendron. “Increasingly, a number of the capital structures they look at from day one are targeted at direct lenders.”
But although direct lenders have become a fixed part of the European mid-market funding scene, market observers rebut the idea that they could eclipse the banks.
This is partly because of banks’ continuing pricing advantage for simple deals. Market watchers say that although the gap between what direct lenders charge and what banks charge has narrowed, it is unlikely to close completely. “The cost of debt is in most cases higher than for commercial banks, because a lot of direct lenders target higher returns,” says Sabben-Clare.
Asked whether direct lenders might gain further ground, EY’s Lowe concludes that their prominence has already “peaked”. He notes that the number of new entrants to direct lending beating a path to his door has eased from a high of one every two weeks at one point.
Lowe even predicts that some direct lenders will go bust. Some have raised capital from investors on targeted internal rates of return that assume they can lend at Libor plus 9 percent, he says – compared with current market rates for many covenant-lite deals of around Libor plus 6.5 percent.
If Lowe’s forecast comes true, and he’s not the only one to forecast some disruptive collapses, direct lenders will have to defend their recently earned reputation as stable and desirable partners. However, because of the close relationships that many have cultivated, they are in a much better position to survive any reputational onslaught than they were even 12 months ago. Having made it onto the speed-dial list for sponsors’ seeking leverage, they are unlikely to be deleted now.
The pros and cons of direct lending
Pro: Funds pride themselves on a quick decision and accelerated execution.
Con: Comes at a price.
Pro: Banks get accused of a tick-the-box approach to lending post crisis. Funds are less constrained.
Con: Implies potentially lower protections and higher leverage could spell problems down the line.
Pro: Borrowers have greater choice.
Con: Brings with it commoditisation and with so many managers seeking market share, there’s the potential for unhealthy deals to get done.