In a European private debt market dominated by the region’s largest players – UK, France and Germany – the south of the continent is often overlooked, and for good reason. Southern Europe, which for the most part comprises Italy and Spain, was slower to kick off its deleveraging programme after the global financial crisis than the rest of Europe. The unique regulatory and macroeconomic character of these jurisdictions also makes investing a complex affair that demands both deep local knowledge and a greater appetite for risk.
Nevertheless, market participants report growing investor demand and increasingly complicated deals, both signs that the private debt market in southern Europe is maturing. Furthermore, PDI data show that this is against a backdrop of increasing fundraising for funds focused on Europe as a whole.
It is little surprise then that deal activity focused on the south of the continent has increased. Deloitte, which publishes quarterly data on European direct lending activity, tracked 26 deals disclosed by lenders across Spain and Italy in the 12 months leading up the second quarter of 2017. The figures compare with 21 deals for the same period a year ago and just eight deals two years before that. Floris Hovingh, a partner at Deloitte, predicts significant growth in the southern European private debt market in the next five years.
Eyes are on Italy following rules introduced by the country’s central bank last year that allow alternative investment funds to provide direct lending, aimed at improving access to finance for small- to medium-sized enterprises. Hovingh adds that the market has developed over the past five years to the point that managers that had previously executed deals on a tight remit have now become able to target investments more broadly.
“Now that managers have shown strong track records, and the asset class is more established managers have been given more freedom in their second or third fund, including lending to southern European companies”
“Now that managers have shown strong track records, and the asset class is more established, managers have been given more freedom in their second or third fund, including lending to southern European companies,” he says.
“Certainly, over the last 18 months managers are pushing the boundaries in terms of geography and southern Europe is, for many direct lenders, now seen as part of their remit.”
Despite political upheaval stemming from the Catalonia independence crisis that erupted in October, Spain is also increasingly attractive to alternative lenders. Adriana Oller, founding partner of Resilience Partners, a Madrid-based direct lender focusing on the Iberian small to mid-cap market, expects more pan-European direct lending funds will target deals in Spain in order put capital to work. “Companies are getting used to us,” says Oller. “Private debt is becoming more and more known [and] we are seeing more and more deals. People are more accustomed to the asset class.”
Several large private players have also made investments in the region, including Pemberton, Alantra and ICG. Meanwhile, Blackstone’s GSO has been involved in some landmark unitranche deals in Italy including the 2016 merger of chemical group Polynt and Reichhold, and a €40 million loan for Italian tyre wholesaler Fintyre. However, a lot of activity is coming from some very active small to mid-sized players.
Resilience Partners held a first close for its first fund on €40 million in August. The firm expects to hold a final close on about €100 million with a hard-cap of €150 million within months. Then there is Madrid-based debt provider Oquendo Capital, which beat its €150 million target for its third fund earlier this year.
Investors’ improved experience in the private debt market has led them to seek niche strategies. Buoyed by confidence in the region’s economic recovery, southern Europe is benefiting from the rising interest in deals outside the traditional northern European market.
“Spain is a smaller market which is less competitive than larger markets,” says Alfonso Erhardt, a founding partner of Oquendo. “There is more interest in Spain than four years ago. The economy is doing very well. Four years ago, I would say very few investors had interest in a regional fund in southern Europe. We are now witnessing greater LP interest in niche or regional strategies.”
Cheap long-term funding from the European Central Bank to stimulate lending has enabled banks to provide competitive financing to European companies, adds Hovingh, who says it would take a reduction in ECB funding to level the playing field for bigger deals. In the meantime, direct lenders are seeking more specialist transactions – smaller, founder or family-owned businesses and companies without long financial histories.
Oller said requirements for large banks to set aside regulatory capital for longterm deals meant they struggled to provide terms beyond a few years.
She says: “Our target companies get short-term debt from banks of up to three to five years and don’t have options for the long term. We do up to seven years. They can grow little by little. They could consider private equity, but generally disregard it as they do not want to lose control, or consider a direct lending fund focused on long-term solutions.
“Our target market is too complex for [the banks]. A €4 million-€15 million deal is too small to go to the structured debt of banks. They start at €25 million for a syndicated loan. For the regional bank or branch, a €4 million or €15 million deal over seven years is too complex … it requires due diligence, to be flexible and the ability to adapt to the company’s needs and timing, they’re not used to that.”
Erhardt adds: “We are seeing a number of mezzanine deals complementing local banks’ senior debt tranches. Unitranche lenders are facing stiff competition from banks so they are focusing on complex structures and high leverage situations.”
Rafael Torres Boulet, head of Iberian private debt strategy at asset manager Muzinich, agrees the small-cap market was gaining traction with direct lenders. “There are now plenty of pan-European private debt funds operating out of London looking to deploy €30 million to €100 million per transaction,” he says. “If we focus on the lower middle market, it is much less populated and it is more about local players with presence on the ground.”
He characterises much of the direct lending activity as flexible finance, or transactions where entrepreneurs need to raise expansion capital for their businesses but that do not necessarily want to sell or lose control of their companies as they would with traditional private equity.
The nature of the businesses likely to secure alternative lending raises questions about risk, according to Hovingh. Founder or family-owned companies are likely to demonstrate different standards of governance than large businesses or those owned by private equity.
“There’s more risk involved financing a founder owned business as lenders are more reliant on the owner, often the key driver of the business, and lenders need to be willing and able to act as the equity sponsor if things go wrong,” he says. “Hence lenders will need to be rewarded for this extra risk and often ask for equity upside in higher levered sponsorless transactions to align interest.”
Erhardt agrees that non-private equitybacked borrowers would require greater due diligence from lenders, saying: “It is not necessarily more risky but since not all of the family-owned businesses – which would fall into the sponsorless category – are properly professionalised, your addressable market shrinks.”
However, for Oller, whose Resilience focuses on non-private equity-backed companies, the market opportunity is enormous. She highlights the vast majority of businesses in Iberia have no private equity investment, giving the firm a potentially huge pipeline of deals.
Direct lending has become an important feature of the southern European debt market but lenders will rely on greater knowledge among borrowers for their businesses to grow, says Hovingh. Meanwhile, political unrest in Catalonia has raised questions about Spain’s economic recovery and practitioners will be waiting for the ECB to wean European banks off of cheap funding before anticipating a surge in senior debt lending.