The leveraged lending landscape is being fundamentally reshaped. Banks, once the dominant source of debt for mid-market corporates, are ceding market share to funds and even insurers.
Europe is in the process of moving closer to the US model of direct lending to small and medium-sized enterprises, where 80 percent of SME leveraged lending is estimated to be non-bank. And regulation, often seen as a burden for the financial services industry, has been the primary driver of this shift.
“In the past, banks were using their balance sheets as a conduit to foster other revenues, but requirements to hold increasing amounts of capital against debt tranches, especially non-amortising, mean they’ve been forced to retract,” says Christopher Domenghino, a principal at European fund of funds manager Alpha Associates, which is currently raising its first private debt fund of funds.
Many of the players which have stepped into the space are the mezzanine funds which found a niche providing subordinated financing prior to the financial crisis. Tightening capital requirements have opened up the lending landscape and these funds have moved down the risk spectrum to provide senior debt, stretch senior or unitranche.
Ardian, which is investing its third private debt fund, is a case in point. “Our first fund, in 2005, was all mezzanine. Our second was half mezzanine, half unitranche, and our current fund is 60-70 percent unitranche,” says Mark Brenke, co-head of private debt at the European investment manager.
LP’s hunt for yield in a low interest rate world propelled fundraising in recent years, leading to crowding, and new methods of deploying capital.
“Managers are onto their second and third funds with two or three times the capital and many have responded by moving up in deal size. In some cases, the unitranche has gone to up to €100 million. We see funds from €75 million to €2 billion competing and chasing similar deals. Leverage levels are increasing, covenants are slipping, and people are getting more creative about tranching the unitranche,” says one European debt fund manager.
The same manager adds that funds have begun to self-originate sponsorless deals rather than increase deal size.
Brenke notes that size has been a clear driver of growth, with firms like his moving into territory previously covered by syndicated loans, or even high-yield debt. Meanwhile, more complex strategies are evolving, as is the case with first out, second out structures.
“Banks like having some of the long-term drawn debt but a lower risk level, so we have seen deals where you bifurcate the unitranche and make a first tranche of the unitranche, so if proceeds had to be distributed they’d be first in line, and then the second tranche is held by the fund.”
He also notes the rise of sponsorless deals, but cautions that a non-sponsor-backed company and a debt fund don’t necessarily have the same alignment of interests. A private equity fund owner on the other hand has a similar strategy as a debt fund in terms of fund life, return expectations over the period and company hold time. As capital and complexity grows, regulators are taking greater interest. And here, Europe’s experience will not match the US. “The US has the benefit of a single jurisdiction and therefore a single regulatory approach. [By contrast], European countries have started to introduce their own rules, resulting in various regulatory hurdles for cross border lending in Europe,” says Martin Schnaier, head of private debt and capital markets at Sanne Group.
France and Germany are the latest two European countries to set their own rules, getting out ahead of an EU-wide approach to debt fund regulation.
In April, France’s market regulator, Autorité des Marchés Financiers, published proposals for a framework that would end the ban on primary loan origination by funds.
Around the same time, it was decided alternative investment funds in Germany were no longer required to obtain a banking licence to conduct loan origination business. Italy changed its rules this year to allow direct lending by investment funds to companies, and Ireland did the same in 2014. Managers see the advantage in a patch-work of regimes. “We live by regulatory arbitrage,” says one European fund advisor.
Market participants are pragmatic about the regulatory changes on the horizon. Ardian’s Brenke says he sees regulation as being positive for private debt.
“It’s more sensible to encourage a deeper capital market structure with different sources of capital,” he says. “As we saw during the financial crisis, a concentrated financing market can seize up quickly. The US has a deep and diversified financing market and recovered more quickly than Europe.”
Schnaier believes that while many regulatory challenges may lie ahead, “it is the effects of Basel III among other regulatory frameworks that created the opportunity for direct lending in the first place.”
Ending regulatory arbitrage
This year the European Securities and Markets Authority called for a standardised EU approach to loan origination by investment funds. Designed to prevent regulatory arbitrage, some believe the approach contains pitfalls.
“While a common regulatory approach would help, it introduces further regulatory burden on a part of the finance industry that is currently nimble and able to deploy capital relatively quickly,” says Martin Schnaier, head of private debt and capital markets at Sanne Group.
“Imposed rules could be materially different from individual country rulings, thus requiring a potential change to how funds are managed and administered on an ongoing basis.”
Schnaier adds that political changes, such as Brexit, will alter the conversation to a certain extent, with the UK being a key player in the European direct lending landscape.
“Many European managers already believe that the requirements under the Alternative Investment Fund Managers Directive are suitable and that direct lending does not require further regulation,” he says.
“There is potential for dissent from member states who will lose from regulation that creates a completely level playing field with no regulatory arbitrage; and the fact that ESMA’s focus has been on primary lenders and not secondary market participants.”