Annual Review: Making hay in Europe

While it’s possible to argue how wise it is for managers to openly tout that they can compete with the syndicated loan market, the fact is that even three years ago an alternative lender putting up €300 million by itself would not have been considered possible. This year, though, Ares did so when it backed the acquisition of international tax refund group Fintrax by listed French sponsor Eurazeo.

Even a club of four doing a $400 million deal would have stretched imaginations, and yet in September ICG teamed up with Hayfin before Highbridge and Sankaty also joined the financing for Chiltern, the clinical research company. The deal was also notable for the fact that Chiltern is controlled by a trust, not a private equity sponsor. The shift is significant because it marks a change in the attitude of both borrowers and alternative lenders.

The debt funds now believe that they can source and execute these deals and have the capital to do so. Ares’ European private debt co-head Blair Jacobson says he has no doubt similar large deals will come their way in 2016.

On the borrower side, it now speaks of a conviction that alternative lenders will behave like bank lenders rather than the private equity funds or distressed debt managers that many of them are owned by or linked to.

So while not all investors are keen for their managers to focus on replacing banks in larger deals, the shift was a significant one for private lenders in Europe. A criticism often levelled at non-bank lenders is that they are doing much riskier deals than their banking counterparts. That’s not the case, however, says Investec’s head of debt advisory, Jason Green. Debt funds are seeking good quality credits with a diligence process that is in some cases even more intensive than that of a bank.

They seek a premium by offering speed, flexibility and juicier leverage. Green, however, is sceptical that all debt managers are created equal in terms of offering something that different to a bank deal.

“A fund will be a little more creative than a bank, but I think that’s often overplayed. There are – particularly in real estate – funds that are pricing much wider than commercial banks and have as boilerplate an approach. As an advisor, I don’t find that a particularly impressive pitch to the market,” says Green.

There were 92 unitranche financings executed in Europe last year, according to the Altium Mid-Cap Monitor. That’s up almost 30 percent from the 62 such deals recorded in 2014.

And while private lenders do not limit themselves to extending unitranche loans, the instrument is one of their major selling points and can be viewed as a fair proxy for their activity in mid-market lending.

Many debt managers claim that once a sponsor uses a debt fund or unitranche, they rarely go back to traditional bank structures, finding them restrictive in comparison. Others, mainly debt advisors, point out that unitranche structures are not nearly as good value as debt managers’ claim.

“The funds are looking for high quality deals, just the same as everyone else. A key difference is their willingness to put a little bit of extra leverage into the deal, maybe half to one turn. And so, if leverage is king in a deal, then that might be worth paying for,” says Green.

But that extra leverage comes at a very high cost, Green notes, a cost that often isn’t worth it. If a fund is seeking 10 percent to finance a transaction with 3.5x leverage, then the bank financing with a 400bps margin and 2.5x leverage often looks like the better option.

Several other fellow debt advisors agree with Green’s assessment, including Swagata Ganguly, a senior managing director and head of European debt advisory at Evercore. The high pricing often demanded by alternative lenders is a big stumbling block in their march towards even larger market share, they conclude.

Of course debt advisors, hired to get the best financing deal for their clients, can only be expected to argue for lower financing costs, though, unlike most borrowers, they are not paying the interest rates themselves and have a bird’s eye view of the market. 

Green says that some of the funds are looking for 8 percent all-in on deals, while others have adjusted down to 6-7 percent. And that means convincing investors to accept lower returns or turning to leverage to make up the difference.

Altium, the debt advisory firm, says that debt funds have made in-roads into the German market by accepting lower returns and becoming more flexible on covenants and documentation generally. It said alternative lenders’ share of the German market was flat year-on-year at 26 percent in 2015 after jumping from zero in 2012 to 16 percent in 2013.

Finding a debt fund manager who will own up to reducing their return expectations in Europe is difficult. Ares’ Jacobson says that the firm’s European loan pricing has been stable for the seven years it has been active.

BlueBay Asset Management has lowered its net IRR expectations for Fund II. But then BlueBay was always at the higher end of the return target given its targeting of a higher concentration portfolio of event-driven financing. The first fund targeted 10-12 percent with the firm’s €2 billion second fund aiming for 9-11 percent, as PDI reported last year.

Debt advisors argue that in the long-run, private lenders will have to increase their return expectations.

In the shorter-term, however, debt funds are seeking to make hay while the sun shines. With the US and European high-yield bond markets all but shut in the opening weeks of 2016, alternative lenders smell opportunity. It’s not nearly as pronounced in Europe as in the US, where margins have bolted up by a clear 100bps or more over the last six months, but there are good, juicy deals to be done while volatility persists, argue lenders.

One danger is that Europe will miss out. A lot of money has been raised for mid-market corporate debt and European banks – rarely noted for their discipline – aren’t backing away from the challenge.

The other, albeit unlikely, risk is that the volatility that has thus far furnished debt managers with opportunities prompts a fresh downturn that hits portfolios with a wave of defaults.

The bears argue that stock markets are overdue a correction on the back of high CAPE ratios (cyclically adjusted price-to-earnings ratio) – a sometimes prescient leading indicator. Other tail risks include potential global financial turmoil on the back of a hard landing for the Chinese economy and the knock-on effects of a substantial slowdown in emerging markets which have driven global growth for five years. On top of all this, a rising dollar means the supply of cheap debt to the rest of the world has dried up. 

The worst case scenario, however, is unlikely, says Evercore’s Ganguly.

“M&A will slow down, asset prices will come off a bit, [loan] pricing will rise and leverage is going to come down, but I don’t think it will grind to a halt because there’s so much pent up demand for M&A,” he says.

That demand for assets combined with significant volumes of debt coming due in 2017 and beyond, should keep European lenders busy this year.

Bigger fish
The upper end of the mid-market is becoming more exclusive

The proponents of larger deals argue that there are far fewer players that can finance the upper end of the mid-market either alone or as part of a small club.

It’s true that there are plenty of alternative corporate lenders focused on mid-market lending. Most are restricted from larger deals by the size of their fund with only a handful of lenders able to boost funds of more than €1.5 billion-€2 billion.

With a concentration of deal-hungry alternative lenders in the €30 million-€70 million deal bracket, lending conditions for borrowers with lower enterprise values (and therefore higher overall risk), are getting frothy, say the managers writing the biggest tickets.

But is competing with the syndicated bank loan market really any less of a compromise?
Banks have a much lower cost of funds than private debt funds – at least for the moment. Leveraged loans in the upper mid-market typically carry margins of 350bps-500bps and it’s difficult for a manager to manufacture a 9 percent net IRR out of that.

Can the real direct lenders please stand up?
The challenge of sponsors vs sponsorless

More and more debt funds are looking to the large pool of sponsorless borrowers to deploy cash. Debt managers that don’t target this market shouldn’t be calling themselves direct lenders, PDI argued earlier this year.

And the summation by Investec’s Jason Green of the difference between covering sponsors and sourcing unsponsored transactions reinforces that view. “Debt funds are increasingly looking at the sponsorless market,” he says. “Deploying capital in the sponsor market involves 15-20 lunches to cover the market.

In contrast, deploying meaningful volume into the corporate market involves lots of trains and planes to find opportunities. And then there’s a pricing question there too.”

Five Arrows, Prefequity, Pemberton and Beechbrook are all making a push into the non-sponsor-backed arena. The waters are murkier – there’s no private equity due diligence report already done and sourcing is a challenge. But the opportunity set is much, much larger than the leveraged finance market.

Seeking another angle on the non-sponsored side, Arbour Partners has established Arbour Capital to bring together non-bank lenders with SMEs seeking finance.

James Newsome of Arbour explained the rationale in PDI’s sponsorless lending roundtable last year: “There are thousands of these companies in the UK. The trouble is, we’re sitting in St James’s Square, and these thousands of companies, if they think of fund managers in London, they think of hedge fund managers, who go around in helicopters. They are yet to be aware of this kind of capital, which we can provide, which is patient money, match-funded.”

Trendspotting: marketplace lenders
The alternative to the alternative

Probably the most ‘alternative’ of alternative lenders are the marketplace lending platforms, or peer-to-peer (P2P) lenders. With a large number of institutional investors piling into the sector, P2P probably isn’t the most accurate of monikers these days, but it is catchier than marketplace.

Several managers sought (and successfully raised) permanent capital to invest into assets originated by a number of marketplace lenders in the US and Europe, including Victory Park which raised £200 million by listing VPC Specialty Lending on the London Stock Exchange in March before raising another £183 million in fresh capital in September.

Ranger Direct Lending followed before marketplace lending platform Funding Circle offered its own fee-free UK investment trust, raising £150 million in November.
The London-listed investment trust structure became the permanent capital vehicle of choice for these market place lenders.

Elsewhere, the platforms gained traction with authorities and more established financial institutions when the UK government gave the go ahead to a new P2P version of an established tax-free saving scheme and Royal Bank of Scotland announced a deal to refer rejected SME lenders to certain marketplace lending platforms.