Senior debt: Beware the wisdom of crowds

With the creation of its debt arm in February, BC Partners became the latest heavyweight private equity firm to enter the private debt space. BC Partners Credit will be led by the former head of Apollo’s US opportunistic platform, Ted Goldthorpe, who is launching the business from the firm’s New York office. It is expected to go to market with its maiden fund this year.

BC Partners follows in the footsteps of other private equity giants like Blackstone, KKR, CVC Capital Partners and EQT. The fact these established players are occupying an increasingly crowded space has not gone unnoticed by others in the industry.

“We may be reaching saturation point for private debt funds,” says Donald Lowe, partner and private equity specialist in the finance team at law firm Travers Smith.

Lowe adds that it is likely the total volume of private debt fund money will continue to increase as large private equity firms enter the market. At the same time, the banks that had originally created demand for private debt funds are making a comeback. With so many managers offering similar solutions and chasing the same deals, the question now is whether there is enough space for everyone and how they can differentiate themselves.

There is no clear consensus on how urgent the crowding-out has become. Lowe admits the overall number of funds may yet fall. “There are funds that haven’t done many deals, and there is increasing pressure on them just to pay the bills,” he says. Unlike private equity funds, private debt fund managers only get paid for deployed capital.

Declan Canavan, head of alternative investment strategies EMEA at JPMorgan Asset Management in London, disagrees with the idea of saturation, but notes the senior debt market is “more crowded and competitive” than a year or so ago.

He adds that, in addition to banks and specialist debt funds, large institutional investors are sometimes willing to make their own loans. Examples include Pension Protection Fund and Legal & General Retirement, which lent £150 million ($188 million; €173 million) and £250 million, respectively, to DP World for its London Gateway Port.

Moreover, Andrew McCullagh, managing director at Hayfin Capital Management, a €9.3 billion European mid-market lender headquartered in London, thinks the banks’ presence is growing.

“Around 2013, many banks picked up their lending activity, stepping off the back foot,” he says. “Today, in some markets, banks have even stepped onto the front foot, while very much still marching to the tune of Basel III”, which restrains bank lending by requiring more capital to back it up.

One reason why the senior debt market is more competitive is the limited number of places to put all this money and the relatively meagre dealflow coming from that. Richard Roach, head of mid-market leveraged finance at Royal Bank of Scotland in London, blames this on a degree of uncertainty.

“There are a host of elections that are causing people to wait and see, and Brexit’s Article 50 also makes entrepreneurs nervous,” he says. “A lot of people are watching and waiting before they take on debt.”

So how is this competitiveness revealing itself in the senior debt market? Market participants have noticed some spread tightening.

“Spreads in our particular market [mid-market loans made to European companies with an enterprise value of €100 million-€400 million] are fairly stable, but no market can be immune to spread compression,” says Thomas Duetoft, London-based head of origination at Pemberton Asset Management, which has a €1.2 billion senior debt fund.

A senior secured or unitranche loan that would have been priced at 700 or 800bps above Euribor in 2016 might these days be priced at 650bps, he adds.

Lowe says many funds with lower costs of capital and internal rate of return expectations are targeting stretched senior debt, which sits 600-800bps above benchmark for unitranche loans offered by funds and the 350-450bps spread for the senior debt offered by banks. He has also heard of funds “being brutally competitive and pumping high leverage even into pretty small EBITDA businesses” – perhaps as much as 6.5 times EBITDA of €10 million. Lowe adds: “That’s something traditional banks can’t compete with.”

Looser terms

Market watchers have also noticed a trend towards looser covenants – even among banks that have traditionally been more accommodating towards large borrowers, but spreading this largesse downwards. “At the lower end of the mid-market banks still insist on and get the full suite of covenants: leverage cover, interest cover, cashflow cover and capital spending,” says Roach.

“But the bigger mid-market borrowers, and large sponsors, want looser terms. At the very least banks have to accept cov-loose deals, perhaps with just one covenant for leverage.”

Such borrowers might even get proper cov-lite deals, where there is no financial covenant. “There’s no doubt that at the upper end of the mid-market” – for businesses with an enterprise value of about £250 million – “terms have loosened over the last six to 12 months”, adds Roach.

Large funds argue that their liberal approach to covenants is perfectly sensible and sustainable. Canavan denies that this reflects competitive pressure in the case of JPMorgan Asset Management’s funds. Instead, he thinks that they reflect the sophistication of lenders that know businesses sometimes need more complex loan terms, or at the very least a sympathetic approach to covenant breaches, to reflect their particular industry. For example, if the firm’s debt fund held loans made to a European retailer that would be breached if sales volume fell below a certain level, it would not call in the loan automatically if it felt that the retailer was making operational progress.

Other fund managers argue that they are relatively immune from competition because they have found a niche. Duetoft says that the niche Pemberton likes is senior loans of €45 million-€75 million to B+ to BB- businesses, originated locally from five cities in Europe. “This segment has been relatively stable,” he says. “There are certainly less than 10 pan-European funds in the senior secured market.”

Observers notes that many funds rely instead on originating loans entirely from London, even though nearly all aspire to lend to more than just UK companies. McCullagh of Hayfin says that the proportion of deals sourced from its five offices in mainland Europe, from Madrid to Frankfurt, has risen in recent years, in part because Hayfin’s team has focused on originating deals in markets less crowded than London.

Madrid and Frankfurt are hardly akin to the frontier markets that emerging stock markets fund managers visit, but in the London-dominated world of leverage loans they are sufficiently exotic to offer opportunities.

US: confidence and leverage on the up

The election of Donald Trump as US president has shaken the world; it has also, to an extent, shaken up the US senior debt market.

“As we headed towards the US election there was a sense that the economy was slowing, so funds were acting cautiously,” says Paul Echausse, New York-based managing director and head of US direct lending at Alcentra, a BNY Mellon investment boutique focusing on the mid-market. “But there is now a sense of renewed optimism about the US economy: a sense that we are no longer in the seventh inning of a nine-inning game, but perhaps in the fifth. Given this, we would expect funds to be receptive to higher leverage.”

This, he says, has led to “probably 25-50bps of interest rate compression over the past three months” – pretty rapid for the loan market. In addition, “a little bit more leverage is starting to creep even into the lower mid-market”. A business that might have borrowed at four times EBITDA before might now be able to borrow at 4.5x.