Beechbrook Capital’s new London office is situated in the West End, so it’s perhaps appropriate the four executives gathering around its boardroom’s table are about to speak on a subject laced with drama – developments in the UK private debt market.
Less than 24 hours after this meeting, Prime Minister Theresa May announced the triggering of Article 50 and the formal process removing the UK from the European Union. What follows, according to the cohort, is two years of uncertainty for Europe’s most substantial private debt market.
The UK, with its established private equity industry, is Europe’s premier market for private debt deals. “I would say about 40 percent of [European] transactions are being done in the UK,” says Floris Hovingh, head of the alternative capital solutions team at Deloitte.
Despite the uncertainty, there is a sense of confidence in the future of the asset class. The likely disruption caused by Brexit can be a source of potential opportunities and it’s on the positive side that some of the participants prefer to keep their focus.
“There will always be economic and political events that can have either a short-term positive or negative effect, but I think the private debt market is going to continue to grow through this,” says Steven Clark, founder of Omni Partners.
“If anything a bit of volatility means that the competition, and in this case it is the banks, will be less active. It is quite interesting how that works, because you end up with a cycle with the banks pulling back, but at some point in the future they have to come back into the market.”
Jon Herbert, managing partner at Beechbrook Capital, who oversees the firm’s UK-focused investment strategy, is not convinced Brexit represents the right direction for the UK.
“I don’t think it has been positive for the market overall,” he says. “And I don’t think it’s going to be positive until it plays out. There is an overall macro shift going on here and I think that the banks are more likely to take a negative reaction to their business than we will as entrepreneurs running a small business that has long-term benefits.”
Despite this, Herbert points to his own fund, which he started raising before the EU referendum, as an example of success amid uncertainty. The offering reached a final close at the beginning of this year. “We got a fund closed well with a number we were happy with,” he says.
On the subject of fundraising, Clark also notes he’s been able to meet targets despite the referendum’s outcome. There have, however, been some bumps in the road.
“We were holding a close for our third fund, which was predominantly US money and most of it got pulled,” he says. “It was frustrating for the business, but Article 50 has now been triggered and we’re holding the final close for that fund now. The investors who pulled have come back and increased their allocation, so we now have much more capital available than before.”
A sense of caution has consumed the UK, with people watching the value of their pounds plunge. The fall in sterling has likely had a strain on some mid-market companies with the latest figures putting inflation above the Bank of England’s 2 percent target. A drop in UK M&A activity has also closed off a number of opportunities for private debt firms to invest in small and medium-sized enterprises. The tide appears to be turning, however, as the market reconciles itself with the new reality.
“In terms of what we’ve seen in the months immediately post-Brexit, lenders did hit the pause button on more complex transactions to see how Brexit would impact the market,” says Hovingh. “However, the market has quickly returned even though we still don’t know what Brexit means. That is going to take another two years, if not more.”
Preparation for whatever outcome arises is already underway at some of the leading financial institutions as they question what type of Brexit will be emerging from the negotiation process. Hard-Brexit, with a cap on immigration controls, and soft-Brexit, with continued access to the EU’s single market, is shaping the debate in the UK and either route will force firms to assess their strategy.
Peter Brown, head of funds banking at Royal Bank of Scotland, says the bank is expanding its presence in Europe as a result of private funds rethinking their operations. “RBS International now has a branch in Luxembourg as a number of our debt fund clients are focusing on where they raise the capital. “There is still uncertainty around the UK, and whether it will be securing passporting rights and whether some form of equivalence is negotiated as part of a Brexit deal.”
Despite the looming uncertainty around Brexit, the presence of private equity sponsors has historically bolstered the number of opportunities for non-bank lenders in the UK. While there are a significant number of mid-sized businesses owned by private equity firms, the continent is a different picture.
“If you look at the rest of Europe, you see a lot more family-founder-owned businesses,” says Hovingh. “Trying to source family-founder owned businesses is a lot harder and often you will need an intermediary to access these opportunities. Sourcing sponsor-owned businesses is much easier with the private equity house being a single entry point to lots of dealflow.”
That’s not to say, however, the growth of the UK’s private debt market is dependent on the sponsor-backed space. As musings around the table continue, two points become consensus. Firstly, the universe of sponsorless mid-market companies is much bigger than those backed by private equity. Secondly, there’s a great opportunity in seeking said businesses out since they tend to be neglected by traditional financiers.
“They’re underserved two ways,” says Herbert. “They’re sponsorless, so it’s less targeted by most of the credit fund market. And we’re in the SME space and typically they’re under-served compared to the bigger companies.”
Herbert’s fund targets sponsorless borrowers. He notes being involved in this space often leads to identifying a greater number of potential borrowers compared with the private equity-backed space. “There are thousands of target clients in my space,” he says. “How many private equity deals get done every year in the UK? About a hundred? The potential target market is that much greater.”
Lenders on both the banking and non-bank side share the common goal of wanting to support SMEs in the UKs. “It’s a really important market for all of us,” says Brown. “We’ve all got a responsibility to support businesses and help them to deliver growth, create jobs and create an environment which is successful for the UK.”
The projected increase of lending to UK SMEs over the near term is something Brown says is also worth noting. “The growth is projected to be over 100 percent per annum and private finance coming into the market will be an increasing trend,” he says to agreement around the table.
“We are heading towards the US model where much more credit is provided by non-bank lenders,” Clark says. “I think that trend is inevitable. As a consequence, the ability of non-bank lenders to provide large tickets will develop as well.”
Since only a few managers have the scale to underwrite large loans presently, the real growth of the industry may be through lending to the smaller end of the market. “There is a distinct place for smaller players as this is an underserved market,” says Hovingh. “This is the area where banks have retracted and debt capital is scarce.”
That’s not to say bigger deals aren’t being seen. The UK is not quite at the stage where tickets as large as $1 billion are being written, but there are players able to pursue larger deals. Tickets of about half this size are seen from London-based debt funds, Hovingh notes.
Identifying financing gaps in the UK economy is only half the battle. Loan origination requires fostering relationships. “There isn’t one answer in the UK,” says Clark. “We have direct businesses and we have broker-disintermediated markets as well. Our biggest market within real estate lending is broker-disintermediated, although the percentage of business that we do that is directly originated is growing.”
For Herbert, origination requires a mix of education and managing ties with the traditional lenders – the banks. “I see my job as all round trying to educate not just the companies but also advisors,” he says. “Getting people used to taking money and borrowing money from a fund-type structure or a fund-type provider is a developing game in my opinion.”
Herbert also notes a good relationship with banks is important when finding borrowers in the UK non-sponsored universe.
Brown adds there are instances when these companies would want a combination of bank and non-bank funded debt with varying seniorities.
“I think what you tend to find, across all markets, is certain clients where they are perhaps in the growth phase or where perhaps senior debt isn’t appropriate for their whole financing needs,” he says. “The key point is to get involved, to understand the business and the strategy, and to try and introduce the right people to support their growth.”
The search for yield has been pushing many investors to expand allocations to alternatives covering increasing liabilities. Interest rates remain at historic lows, a hangover from the global financial crisis, putting pressure on pension funds and insurance companies to think of more creative solutions.
“There is a lot capital trying to find a home,” says Brown. “The alternatives base has, across all investor classes, continued to grow given low yields in fixed income and variable returns in equity markets.”
As a result, the private debt market has flourished in this period of increased investor demand and, as Brown says, is “a more established asset class now”.
Though funds may be focusing on the UK, investors are drawn from a worldwide audience. Clark says the most productive geography to fundraise in is the US – investors there are familiar with the asset class and are more willing to make a commitment.
Private debt is perhaps not as well established as traditional private equity in the UK, but the increased degree of downside protection combined with high single-digit returns for senior strategies and mid-teens for mezzanine means there are many takers.
Clark notes there are signs of increasing acceptance as investors are rethinking where to place their private debt allocation within the portfolio. Many are finding space in their fixed-income sleeves instead of their alternatives buckets.
“The history of the business has been that direct lending came out of the private equity business. But what is happening now is that the direct lending piece has shifted across to come out of their credit allocations,” he says.
Instead of comparing private equity and private debt strategies, investors are comparing it with the returns from fixed-income instruments. Clark predicts a wave of capital entering into the market as that shift in thinking continues to take place.
“Once it starts coming out of that fixed-income/credit allocation then the relative return expectations aren’t much lower, but the volume of money is much higher. And that is a trend that we see. I think there is lots of money coming into the space.”
It’s the clear consensus around the table that investors are enthusiastic about the asset class. But, turning to 2016, there’s a more muted tone as fundraising tapered off amid turbulence on the macroeconomic and geopolitical front.
“In relation to European direct lending fundraising we’ve seen probably half of what was collected from the year before,” Hovingh says. “In 2016, this is not all Brexit related. The year started badly with lots of macroeconomic uncertainty around China, then Brexit and then you have Trump.”
For an asset class expected to gain popularity during times of increased volatility, however, there are numerous other reasons for the fall in fundraising.
As Herbert notes, there was some “over exuberance” in preceding years. “Some of those funds are struggling to deploy capital at the rate they want to, so, there is a bit of normalisation in some of the growth,” he says.
Some of the largest funds were in the market in 2015, meaning 2016 was a year to focus on deploying raised capital. The cycle makes sense with PDI figures showing a similar spike in 2013 and a decline a year later. Across the years, however, the fundraising trend is upwards.
“It’s all a result of larger funds being raised,” says Hovingh. “If you’ve got a fund of £3 billion ($3.75 billion; €3.5 billion) and a concentration that’s anywhere between 5 and 10 percent in a single company name, then suddenly you can do £150 million to £300 million tickets.
“There are probably eight managers that can do that in this market. These are the same businesses that will do volume business at a scale with private equity and those are the funds that will increasingly compete with the capital markets products provided by investment banks.”
Competition among non-bank lenders to the UK market is growing, but it’s not as cut-throat as might be imagined. “We’re in a competitive space, but we shouldn’t all believe it is super-competitive deal by deal,” says Herbert. “I’ve seen lots of transactions where we are the only party talking to the borrower. That’s partly because we’re quite differentiated, but I think it’s also because actually there isn’t that much competition.”
With private debt becoming more accepted as an asset class among institutional investors more players are entering the space, Brown adds. “A lot of private equity firms, or others who were in maybe one line, are now branching out because it’s easier to diversify from private equity or infrastructure into private debt, infrastructure debt or real estate debt,” he says.
The growing asset class is also breeding new types of products, Hovingh notes. “Two years ago, unitranche was the product of choice,” he says. “But, now as the market matures we see lenders constructing new direct lending products for their LP base.”
New products, by extension, means new providers. “As people develop new strategies new players come into the market,” adds Herbert. “It’s not just about big. It’s about big and different. I’m convinced this has many years to move on.”
For Clark, there’s an easy way to gauge competition in the UK private debt space. “The best way to answer the question is: are rates going down?” he says. “If rates are going down then that is being driven by competition, if rates are being held then it’s not an issue.”
As far as real estate debt is concerned, rates are under pressure in the prime lending space, Clark adds. In other areas of real estate debt, however, there isn’t much pressure on rates, hinting competition is not quite at a fierce level yet.
“It’s a really big market, so 10 new lending funds set up and raising £100 million or £200 million each doesn’t make a dent,” he adds. “And the size of the overall alternative space against the bank space, again it’s a flea.”
At the time of going to press, the industry is preparing for the next bout of drama: a UK general election. Set to take place next month the private debt industry will be contending with more uncertainty – something it appears well suited to take on. While further theatrics may not be welcome, it is unlikely to slow down the growth of the asset class.
Working with banks, a complementary approach
The consensus around the table is relationships with banks are necessary for private debt funds to thrive in the UK market. What’s not clear is how seamless this relationship is.
“What we see, and we get this feedback consistently, is that the banks are painful to deal with. Just painful,” says Clark about his clients’ experience with banks. While he notes his firm does have some relationships with banks, helping Omni serve its clients, these also aren’t ideal. “We do have some relationships with banks and we’ve partnered up on some things. It’s still painful.”
The other side of the table has some banking representation. Brown says banks and debt funds can work together, offering clients a full roster of services.
“Banks should not be viewed only as competitors. Banks can work with private debt managers to help deliver operational efficiencies and competitive advantage,” he says.
“I think what we’re seeing particularly in each sector – if you take the sponsored world – we and other banks are partnering more formally with other alternative lenders to provide that end-to-end solution for the private equity sponsor market,” he says.