Analysis: Passive or aggressive

Less risk in going high-yield

“Aggressive” deals aren’t an issue if managers do their homework and participate in a part of the market which lends itself to higher-yielding terms, says Eric Gallerne, partner at Idinvest.

The lower end of the mid-market isn’t as competitive as lending to larger enterprises, Idinvest’s Eric Gallerne notes. Because of this, high yields generated by lending to such companies shouldn’t necessarily be seen as a sign of undue aggressiveness.

Rather, it’s a symptom of a lack of options for such borrowers. “There’s very limited alternatives to bank loans in the smaller end of the market,” says Gallerne, speaking about businesses with €50 million-€150 million in EBITDA. “There’s not access to high-yield financing or second-lien financing. It’s only unitranche which bridges the gap.”

At the higher end of the market, where larger corporates with strong credit quality may have access to bank financing, some lenders may be willing to lend lower down the capital structure or take greater risk when it comes to credit quality, Gallerne notes.

“It’s different between the lower end of the market and the higher end of the market. It’s at the higher end where you see such aggressiveness.”

Pursuing deals in the lower end, however, is not without risk. “Clearly, the challenge for us is to stay good at filtering the dealflow,” says Gallerne. Focusing on credit quality and remaining disciplined is key.

Assessing lending from this standpoint is more fruitful than trying to judge when the credit cycle might turn. “I don’t have a crystal ball and I don’t know when the party will end,” Gallerne says.

A bigger risk than a mature credit cycle

Seeking aggressive deals is a risky business, says Nicolaus Loos, managing director at IKB Deutsche Industriebank.

As competition grows, standards of credit analysis can fall in favour of seeking greater yield For all the chatter about it being late in the credit cycle, competition within the private debt space has created another potential bump in the road.

Higher-yielding deals, pursued aggressively by certain lenders, may serve to harm the industry if credit analysis is not up to scratch.

“We’re further down the cycle, but there’s no crack in the wall,” says Loos.

“If you give money to these direct lending funds which offer 8-10 percent, I’d be wary,” Loos said at the PDI Germany Forum in May. Now he notes pricing pressure is causing funds to be more aggressive in terms of the amount of leverage they offer.

Loos also flags the dangers of seeking bifurcated deals alongside banks. Such deals would involve a fund ranking under a bank in the capital structure, while getting a slightly better return on its investment than the most senior lender. In practice, this could turn out to be risky for both funds and their investors.

“A lot of the documentation hasn’t been tested during a down cycle,” says Loos. “We are not aware of any such deal that has gone through a workout.”

While concerns persist over the maturing credit cycle, investors should be taking care when allocating to higher-yielding funds, he adds.