If the credit crunch can be likened to a gigantic vice threatening to squeeze the life out of companies starved of bank lending, then direct lenders and private debt funds are helping to keep the jaws of the vice open in Europe.
In theory, governments and regulators might be expected to look on these funds with favour. In practice, the picture is mixed for direct lending funds, though secondary private debt funds face fewer restrictions.
The past year has seen a wave of deregulation in the treatment of direct lending funds in Europe on a national level – but, at pan-European level, the signs are less promising.
Alan Davies, London-based corporate partner in the European Finance Group of Debevoise & Plimpton, the law firm, notes that over the past year Italy, Germany and France have all seen “a helpful relaxation of the regulations to enable funds to provide direct lending”.
Since February, closed-end alternative investment funds in Italy have been able to make loans to non-consumers, subject to certain conditions such as requirements for risk mitigation and diversification. A month later AIFs were told they were no longer required to have a banking licence under the German Banking Act if they conduct loan origination business.
Reasons for this relatively warm embrace of direct lenders are not hard to find, say experts: all these countries have constrained credit markets.
The most bottled up of the three is probably Italy, where the move “highlights the need, in the government’s view, to promote direct lending as an alternative funding source – particularly given that Italian banks are by and large not in a good state”, says Ping Zhu, senior associate director in the private credit team at the San Francisco office of Verus Investments, the consultancy.
In much of Europe, however, there are still regulatory limits to what direct lending funds can do. These are based in part on the banking licence rules that restrict lending to banks. Even in Germany, France and Italy, these rules continue to give direct lenders less freedom than in the UK, where direct lenders do not face any major regulatory obstacles.
Some lawyers argue, privately, that banking licences can largely be circumvented through ingenious devices such as lending to a bank, which then goes on to lend to the company that wants to borrow.
However, one partner specialising in financial regulation at an international law firm describes the banking licence regime that exists in many European countries as “a real impediment” to direct lending. He asserts that if a fund is in effect lending without a banking licence, “it’s taking a material risk” and adds that it is not feasible for funds to require licences – the corresponding requirement for them to be regulated as if they were banks would be too onerous.
Experts also note that deregulation of lending is necessary, but not sufficient, to produce a thriving market. Davies of Debevoise & Plimpton says that following the easing of the rules in Germany, France and Italy, “we haven’t seen a huge expansion of direct lending as a result”.
Lawyers note that even if regulation is more favourable to direct lenders, the wider legal regime might not be. “Direct lenders are just as interested in changes to bankruptcy rules as in changes to regulations directly addressing lending activities,” says Davies. “In Italy, recent changes to bankruptcy rules have made life better for lenders, but they are still nowhere near as creditor-friendly as in the UK.”
Experts also complain about the provisions in France and Spain. The lack of progress in this area, from the point of view of creditors, “may be one reason why we haven’t seen a rise in direct lending in continental Europe”, says Davies.
Lawyers for direct lenders would also dearly love EU-wide deregulation of direct lending, rather than having to rely on nation-by-nation liberalisation.
“European managers tell me a good step forwards would be to harmonise the legal framework, especially as relates to restructuring,” says Zhu. Restructuring is harder in many European countries, including France and Italy, largely because employment laws make it harder to lay off workers.
The European Commission has announced plans for a consultation on loan origination, but lawyers say no details have emerged about the shape of that consultation.
However, proposals by the European Securities and Markets Authority, an EU regulator, which are designed to feed into the Commission’s consultation, show the need to avoid complacency.
ESMA suggests that managers of direct lending AIFs should be subject to specific authorisation. It also calls for tighter risk management of loan origination.
“ESMA’s proposal, if adopted, would be a mixed blessing at best,” warned Ashurst, the international law firm, in a note published in May. “While it could facilitate loan origination in some jurisdictions if it replaces existing national legislation, it could also present new restrictions, timing issues and costs for direct lending funds.”
Ashurst recommends that sponsors of direct lending funds “should now start to take ESMA’s proposals into account when considering new fund structures and strategies”.
However, some lawyers acting for direct lenders and for the firms that borrow from them are not presently worried that the Commission will make life too difficult for direct lenders.
“I suspect that regulators recognise that the source of liquidity provided by direct lending is important to the financial system,” says Pierre Maugüé, London-based finance partner at Debevoise & Plimpton. “Given this, people will think twice before creating rules that will eliminate that source of liquidity.”
Davies adds: “It’s hard for me to see why European regulators would want to disrupt this market.”
Time will tell whether direct lenders will struggle with a headwind as they try to sail into Brussels, at the same time as they benefit from a tailwind in many of Europe’s national capitals.
BANKS WAKE UP TO A BASHING
In the US, the regulatory arbitrage between the unregulated direct lending market and the increasingly regulated bank loan market is providing progressively greater opportunities for direct lending funds, say experts.
The most important regulation has been guidelines from the Federal Reserve, issued in 2013, which limited leveraged lending. Pierre Maugüé of Debevoise & Plimpton, who is based in London but qualified in New York and still monitors the US market, says leverage levels of greater than six times EBITDA should “raise concerns for most borrowers in most industries”, but borrowers should be able to amortise “a significant portion” of the debt over the medium term, using free cashflow.
“When the leveraging guidelines were originally promulgated, the banks weren’t sure what was required of them, and how the guidelines would be enforced,” says Gary Creem, Boston-based partner at Proskauer, the law firm. “But banks are becoming more sensitive to these issues, because they’re gaining more clarity. This has created more opportunities for direct lenders.”