Europe’s banks are not the force they once were. In the choppy years following the global financial crisis, banks were forced to repair their balance sheets and redirect funds to large, more established borrowers. As a result, finance for mid-market companies (with an EBITDA of around €15 million) shrank.
The retreat of traditional banks from the lending space helped fuel the growth of private debt. In Q2 2016, Deloitte’s latest deal tracker recorded 67 transactions involving alternative lenders totalling €3.5 billion, representing a 3 percent year-on-year increase.
At the same time, institutional investors have been attracted by private debt returns which can outperform equities and fixed income. This is particularly the case with the most senior asset-backed real estate and infrastructure asset classes yielding Euribor plus 250-350 basis points and, for senior corporate debt, 5-8 percent yields, according to bfinance. Both have low loan-to-value ratios providing significant cushion against any decline in equity values.
Asset-backed investments have benefited from favourable regulatory treatment in terms of lower Solvency II capital requirements which make returns generated by European real estate and infrastructure debt particularly attractive for investors.
Laurent Belouze, head of Natixis Asset Management’s real asset private debt division, recalls 2010 as the genesis of the private debt sector in Europe. “The sovereign crisis made investors realise that investing in sovereign bonds was not that secure and that they needed to find assets with less volatility, so they began looking for illiquid loans while maintaining an investment grade risk profile. In the meantime, Basel III and the decline of liquidity for banks pushed them towards an originate-to-distribute model,” he says.
In a context of increased uncertainty, reduced scope for growth and a ‘lower for longer’ monetary policy, there is a heightened search for yield. However, while targeting areas underserved by banks is a well-reasoned strategy among alternative lenders, the gaps aren’t as big as they were. There have been signs that banks are set to return to the space.
“Banks were quite aggressive in the second half of last year, so some alternative lenders in the senior real estate debt space maybe didn’t lend as much,” Natalie Howard, head of real estate at UK private debt asset manager AgFe, which operates in a part of the market in which banks are less active: sub-£50 million ($60 million; €58 million) loans secured against good quality secondary properties.
Following a period of spread compression, pricing has now stabilised in the UK. This year senior loan margins have increased by 50 basis points and advance levels have moved back to 50-55 percent, driven by banks. Some managers, including real estate whole loan debt funds like UBS Asset Management’s Participating Real Estate Mortgage Fund, have had to adapt their approach.
“The whole loan market started to fall away a bit during the middle of last year,” says Anthony Shayle, the fund’s portfolio manager and head of global real estate. “The options are to shift pricing down or take different risks, such as development and refurbishment opportunities to balance up the overall portfolio return, in which case you have to understand the property asset as if you were buying it.”
Concern about banks’ ability to deliver, based on credit committee approval, is no longer a factor driving borrowers towards alternative lenders. Cécile Mayer-Lévi, co-head of private debt at French fixed income manager Tikehau IM, says he expects banks to continue to be active and dynamic due to the quantitative easing still being implemented by the European Central Bank. “You cannot consider that banks are retrenching in the leveraged loan market in Italy, Spain, France, the Nordics and Netherlands,” he says. “We do have many situations where we share some transactions, coming in as a B investor in a structure where banks have arranged financing.”
Alternative lenders’ flexibility in terms of documentation and speed of execution, with regard to M&A transactions, for example, is their main appeal. For this reason, Floris Hovingh, head of alternative capital solutions at Deloitte, notes “it has been a stellar year for direct lending in the Netherlands”.
The reality is one of banks and direct lenders working together, in some cases through partnerships. A recent example being when, in December last year, Royal Bank of Scotland launched a joint venture with Hermes, M&G and AIG, with the aim of writing loans worth up to £700 million in total in 2016. This bolstered the bank’s lending to mid-sized firms while providing a new outlet for the institutions’ funds.
Private debt investment is attractive, despite a shift in the opportunity. “There was a liquidity shortage; now banks are back and pricing is down, investors are driven by the illiquidity premium available over other asset classes,” says UBS’s Shayle.
Tommaso Albanese, head of UBS Asset Management’s infrastructure and private equity unit, Archmore, believes the private debt opportunity “is here to stay” and will continue to grow based on the fact the institutional allocation to infrastructure debt is “still a drop in the ocean compared to what is needed by the real economy”.
Europe’s lending landscape will take time to transition from a bank-monopolised market as players adjust, although private debt has won its place as an established asset class and investors are now building multi-asset style portfolios of debt and moving into new geographies and sectors.
Uneven roads: Europe’s patchwork private debt market
Across Europe, the pace of development is uneven, weighted towards the UK, France and Germany – in that order. This trend is closely linked to the functionality of the local banking market. UK banks are bound by slotting regulations, which require greater capital reserves to be held against riskier loans; France is a bank-dominated market; while in the competitive German market pricing is notoriously tight.
More than ever the future of the region seems unpredictable. Laurent Belouze, who heads Natixis Asset Management’s real asset private debt division, splits Europe into three markets: the UK, northern and southern Europe. He notes the recent impact of the UK’s decision to leave the EU.
“[While] the UK is a big market, non-UK investors are on hold until it becomes clear how things will unfold,” he says. An additional challenge surrounds the fact most of the capital market is euro-denominated so investors have to factor the cost of hedging back into euros into the loan investments they make.
For large ticket lender AXA Real Estate the UK market is still investment worthy, even if there is cause for greater caution. “Spreads have widened, first of all in anticipation of the referendum, and continued after, so it can be of interest,” says Isabelle Scemama, head of the funds group at AXA Real Estate. The trend among UK real estate lenders is that they are either lending lower leverage or making sure they understand value.
“Northern and Central Europe are the safest markets, with margins tight,” Belouze says. “When you go for Spain or Italy you get some country risk premium.”
There has been a significant pick-up in direct lending in Italy and Spain over the past two years, according to Deloitte. Floris Hovingh, head of alternative capital solutions at the firm, puts this down to “continued difficulties experienced by the banking system in Southern Europe”.
Not everyone is focused on jurisdictions. Tommaso Albanese, head of UBS Asset Management’s infrastructure and private equity unit, Archmore, is agnostic about where investments are made, saying his strategy is not specific by country, but by type of transaction.
“Asset managers can add value through one-off deals that require complex credit analysis; large trophy assets such as airports, ports and motorway PPPs are looked after in the syndicated loan market,” says Albanese, whose platform recently financed a portfolio of elderly care homes in Belgium.
Regulation changes in favour of alternative lenders in Italy – through which insurance groups can finance real estate transactions without bank involvement – as well as legislation allowing insurers to invest in direct lending in France, has helped to open up the private debt market.
European investors like Allianz, AXA and BlackRock are now starting to explore US dollar investments. “If you want to play it safe, remain in Europe; if you’re looking for yield you need to look to the US, Latin America, Asia and the Middle East,” says Belouze.