BlueBay Asset Management launched its private debt business in 2011. As one of the early entrants in the sector following the 2008 Financial Crisis, the firm raised €1 billion for it first direct lending fund in 2012, soon followed by a second fund in 2015 of €3 billion. BlueBay currently manages nearly €7 billion across its suite of direct lending and Senior Loan funds, making the firm one of the largest and most established players in the fast-growing European direct lending market. However, with this leading position come advantages as well as challenges.
Q What is your definition of the mid-market and has it changed?
The “mid-market” lacks a clear definition and direct lending funds have redefined their own mid-market focus over time. The first generation of leading direct lending funds were all about €1 billion of AUM in size. To create diversification for investors, these vehicles needed to invest in 20-30 deals in the fund, meaning loan sizes were typically in the €20 million-€50 million range. By the second generation, a small number of managers moved into the €2 million-€3 billion fund size where, to avoid concentration risk, loan sizes have reached €50 million-€150 million. So as firms have been able to raise larger funds they have been able to target deals at the upper end of the mid-market range.
Larger fund sizes enable direct lending firms to focus on upper mid-market lending, which we believe to be the most attractive part of the market – but disciplined investing is vital to avoid making mistakes and doing bad deals. At the larger end, there are fewer competitors, underlying borrowers tend to be larger, more established and more robust and, finally, loan sizes of €75 million-€300 million do not easily lend themselves to bank underwritten or multi-party, club deals. Our ability to take and hold the whole loan is very appealing to private equity sponsors and corporates.
Where I think the “mid-market” ends for us is where the liquid loan or high yield markets begin. We try to avoid competing against these markets, which we see as badly priced, over-levered and with poor lender protections – more than 75 percent of European liquid loan deals are now cov-lite – a very worrying development.
Q Do you see more players scaling up in the mid-market space, or is it becoming more difficult?
We have seen a complete bifurcation of the market. The direct lending market in Europe now comprises over 60 firms with AUM of about €500 million and only six firms with AUM of over €2 billion. The composition of this top group has been consistent since the start of the industry in Europe, with no new players breaking into this group. In fact, what you have seen is that the gap between these larger players and the new entrants has increased for a number of reasons. The first is track record, as we see investors wanting to reinvest with the existing, established managers rather than take the risk of new entrants into the space. Another key element is the team: one of the biggest barriers to entry for new players is building a quality team. Investors look for people who have been credit investors, who have experience investing and managing debt in a fund environment and who have a strong background in origination, execution and portfolio management.
Q Despite these barriers to entry do you still see significant competition?
There is always pressure from competition. One of the big myths out there is that banks aren’t lending – the banks are lending. Despite all the pressures that banks face, direct lending firms account for less than 0.5 percent of the European lending market, so inevitably a lot of lending is still being done by the banks. What we find is that, particularly at the larger end of the market, banks may find it difficult to provide the certainty of delivering the whole loan in a timely way and cannot offer the flexibility that private equity sponsors or corporate borrowers may require. Also, competition from other direct lending funds is less at this end of the market as there are fewer players that can underwrite whole loans of size.
We are seeing some competition from a few newer direct lending firms trying to grow by pricing deals very aggressively to gain market share. We think this is unproductive and will ultimately be to their detriment.
We are also seeing a certain amount of competition from the liquid loan market filtering down into the private debt market. The liquid leveraged loan market is currently very hot, arguably over-heated, with leverage multiples rising, pricing being compressed and poor terms. More than 75 percent of these loans are now ‘cov-lite’, which is extraordinary given the lessons that you would hope had been learned following the financial crisis – but people have very short memories. We consider covenant protection to be vital in preserving capital in a situation where companies underperform due to company specific or economic downturns. I have been impressed by the discipline shown by most private debt firms in resisting these pressures. Ultimately, if we get it wrong, we will not be able to trade our way out of our loans so we need to be extra cautious.
Q Is there any temptation for you to do bigger deals as you raise larger funds?
For us, it has never been about raising the largest fund possible. The limitation that we set for ourselves on fund size is the ability of our team to do proper due diligence and credit analysis on every deal so that we can invest the fund prudently. In our previous funds, we have comfortably invested the whole fund well within our investment period and that means we are comfortable with the rate of deployment of capital. We never want to feel pressure to invest as that is when you start making mistakes and doing bad deals.
Q Will larger deals push more direct lenders into the high-yield market?
As funds have grown, you are starting to see some of the bigger players do loans that effectively compete with the high-yield market. We are very cautious about those sorts of loans because, if you are competing against the liquid markets, you move into the territory of much lower pricing, higher leverage multiples and cov-lite deals. We don’t think that is a good place to be. We like to cover the spectrum of larger, medium-sized and perhaps even smaller deals. We are always looking for proprietary deals and that means we choose to retain a certain amount of flexibility.
Q Do you anticipate non-sponsored deals becoming more of a feature in the mid-market?
I think as the European market develops, there will be an increased focus on non-sponsored deals, particularly as non-sponsor-backed businesses are increasingly aware of the advantages of using direct lenders. From our perspective, we focus on the credit quality of the underlying business and whether there is a responsible owner of the business. In the current market, there are some private equity backed deals we turn down, especially if we think they might be overpaying. The one thing I know from experience is that anything that becomes a problem for the private equity firm soon becomes a problem for the debt provider.
More generally, I believe that the continued pressure on banks’ balance sheets, coupled with the increased demand for loans by corporates as European economies recover and grow, creates a very favourable lending environment for private debt managers. I am optimistic about the future for our industry so long as we continue to provide innovative solutions to borrowers, stick to fundamental investment principles and manage the capital entrusted to us by our investors in a prudent way.
This article is sponsored by BlueBay Asset Management. It appeared in the Mid-Market Lending Report, published with the June 2017 issue of Private Debt Investor