Does wisdom come with experience?

Many direct lending veterans have switched from banks to funds, writes David Turner. But are the old heads wise enough to avoid the mistakes of the past?

Fenton Burgin, head of UK debt advisory at Deloitte, the professional services firm, has noticed a strange phenomenon: the people working at direct lending funds are ageing rapidly.

He does not seek an explanation to this riddle in the cares of office, or some strange medical phenomenon. A clue to this mystery lies, however, in the fact the people at banks’ leveraged finance teams are, by contrast, getting younger.

“Over the last 12-18 months there has been a veritable flow of intellectual horsepower from banks to funds,” says Burgin, whose team advises companies across the UK, US and mainland Europe. This flow includes many of the banks’ most experienced people. As a result, “when I visit a bank the average age of the leveraged finance team in the meeting is the mid-30s. In some of the funds the average age will be closer to 50”.

This testifies to the changing role of banks in European leveraged lending and the growing role of funds.

High capital charges for lending at high leverage multiples have reduced the banks’ incentive to operate in this market, says Burgin. The solution in many cases is to team up with direct lending funds. The bank provides a first loan of about one-and-a-half times EBITDA, and receives the profitable ancillary income from maintaining a relationship with the borrower. The direct lending fund, for its part, receives a higher yield for its loan, because it is not providing the relatively cheap first turn-and-a-half of leverage.

Because the banks are providing the risky leveraged lending less than before, they do not need the large teams of professionals of yesteryear. Luckily for the veterans, the increasing amount of money deployed by Europe-focused direct lending funds has created a demand for their skills elsewhere. Total funds raised rose to a record high of $37.5 billion-worth in 2017, far above a 2014 peak of $26.2 billion, according to PDI data.

The growth in fund money largely reflects the liquidity unleashed by the European Central Bank’s quantitative easing, as well as the desire by investors to find yields better than those in bond markets.

It also reflects a growth in potential deals. “We see a new transaction come through our door from somewhere in western Europe every single working day of the year,” says Neale Broadhead, managing director & portfolio manager in CVC Credit Partners’ direct lending business in London. “That’s more than two or three years ago.”

CVC has recently done deals in Benelux and the Nordic region, where there was previously only limited opportunity. He credits this to an increased awareness of the benefits of borrowing from a fund as direct lending gains a higher profile.

Cynics might argue that given the long experience of the 50-something generation that has transferred from the banks to the funds, they should be old enough to know better when it comes to some lending decisions.

Borrower power

“Europe is a pretty hot market right now,” says Burgin. He finds funds willing to lend at up to six-and-a-half times EBITDA for the best credits, with no interest payments due before the end of the loan. Moreover, private equity firms are sometimes able to borrow against projected future EBITDA based on forecast cost savings from an acquired business, rather than on trailing EBITDA.

The wave of money has given borrowers power in other ways. “We’ve recently completed a couple of transactions that would have been extremely difficult to do three or four years ago on the same terms,” says Paul Bail, European head of debt advisory at Baird, the financial services firm, in London.

“But because of the large number of debt funds we can usually find someone to take on the more difficult situations, if the deal is structured appropriately.”

Bail also notes that rates have come down. Two or three years ago spreads for a business with an EBITDA of £15 million ($21 million; €17 million) seeking a leverage of five via a unitranche were typically 7.5 or 8 percent, he says. Now they are down to 6.5 or 7 percent.

Covenant protection has also declined because of competition. Broadhead thinks that across the market, deals that would have included three or four covenants a year or two ago might have only two or three now.

Responding to these competitive pressures, each lender must choose where in the sand to draw its own particular line. CVC has done deals in line with what Broadhead sees as the new norms of the market. However, he says the firm is keen on retaining leverage covenants plus controls over cash and the use of cash, such as fixed charge cover and capex controls. “We have walked away from deals because of excessively loose documentation or aggressive pricing,” he adds.

Shunning Schuldschein

Thierry Vallière, head of private debt at Amundi, the investment manager, in Paris, says that although he has previously done deals in Germany’s Schuldschein market, where companies raise money through private placement, Amundi is currently steering clear of this market because borrowers now want to raise money without any covenants at all.

He notes that, of the 23 deals that Amundi did in 2017, only two were in Germany. This is because of the steep competition, which nullifies the inherent attractiveness of the German Mittelstand based on frequently strong market positions and healthy export orders. By contrast, he estimates the opportunity set has grown in Italy as more companies show willingness to borrow from funds – six of the 23 deals have been done there.

Most observers say it is too early to talk about funds posing systemic risk, if only because they are not yet large enough.

However, funds are getting both bigger and bolder.

One seasoned observer warns: “As these funds get bigger, I’m sure the amber lights will start to click on as central banks across Europe start to think, ‘We should look at this.’ ”