On the face of it, European private debt markets are struggling – at least in terms of transaction levels. The latest Deloitte Private Debt Deal Tracker shows the number of transactions declined to 363 deals completed in the second half of 2022 across Europe, down 16 percent compared with the first half, with Q4 figures falling 10 percent on Q3.
Yet despite the challenging macroeconomic conditions, 2022 deal activity for private debt only slightly lagged the full-year totals for 2021, reflecting the resilience of the asset class and its ability to move beyond sponsor-driven M&A as a source of lending.
Leading players expect the market to pick up in the third and fourth quarter of 2023 as banks retrench and private debt funds win greater acceptance as a source of direct lending.
Natalia Tsitoura, partner and head of European origination at Apollo Capital Solutions, says she has never been busier. “This is a great time for private debt,” she says. “That obviously stems from the state of the syndicated loan market currently and the banking system, which creates a gap for private debt to step into. It is also because, while M&A volumes are significantly down, the opportunities coming through our door are different in nature and are ones we are really well placed to respond to.”
Tsitoura says there is “a huge amount of inbound interest” for different types of financing solutions to help address maturities in volatile capital structures. These could involve a sponsor looking to go through an amend and extend and wanting to sort that with more subordinated debt. It could be a sponsor looking to raise financing on a portfolio of assets using low LTV NAV lending. Or it could be a partial realisation on a single company or portfolio of companies to help get capital back to investors to support a fundraising.
“The opportunities are much more diverse and having flexible capital today is a real differentiator,” she says.
Total deals across Europe
This is a view shared by John Empson, managing partner and co-head of CVC Credit, who says the themes emerging in European leveraged finance today are market dislocation, limited bank underwriting, muted new deal M&A and a focus on portfolio and add-on M&A. Private credit, he says, is standing out as the natural place to turn for certainty and reliability of financing.
“The majority of corporate private credit assets sit in direct lending funds that hold mainly first ranking senior secured assets, so the chances of any material distress should be pretty low,” he says. “Naturally, some segments and businesses may be more impacted by the current environment, which can test resilience, performance and cashflow, particularly as higher interest rates bite, but if your asset selection was decent then this is unlikely to be a material feature.”
There have undoubtedly been winners and losers across European geographies, with the UK failing to dominate European private credit activity in the second half of 2022 as it has done previously.
Andrew Cruickshank, head of the Deloitte Private Debt Tracker, says: “One of the themes that jumped out for us in Q4 is that, similar to private equity, the UK has until now acted as the mothership of private debt in Europe and for the first time last year we saw more deals in France than we did in the UK.
“For the first time last year we saw more deals in France than we did in the UK”
“A lot of that was the impact of the mini-budget. France accounted for nearly 30 percent of European transactions in the second half of 2022 and that was up 30 percent, whereas activity in the UK dropped by 20 percent, so there was a real shift in where private debt managers were deploying capital.”
Cruickshank says this UK/Western Europe dynamic feels like it is continuing into this year with a lot less activity in the UK.
“Similar to their private equity counterparts, private debt investors have long dated commitments from their own LPs that they need to invest,” he says. “With M&A activity stalled in the UK, managers are giving more thought to how they originate business overseas – historically, most operated exclusively out of the UK. However, a number of the more developed managers are now capitalising on their investments in a hub-and-spoke model, having recruited local expertise.”
Debt funds are benefitting not only from the chance to snare market share away from banks, but also from having a floating rate product with better protections in a lender-friendly environment.
Chris Bone, head of private debt in Europe at Partners Group, says they are seeing attractive returns available to direct lenders in both the US and Europe. “We are looking at margins of up to 7 percent, sometimes higher, and when you add the base rate to that the overall yield could be above 10 percent in some cases, which is very high,” he says.
“For an investor in this asset class today, coming with fresh money, it is very attractive not only because of those economics but also the stronger legal terms that are improving the risk/return offering to a lender.
“Looking forward I expect Q3 and Q4 to be pretty active because there is pent-up demand. We are aware of a lot of M&A processes that have been put on ice, and financing needs that have stalled, but those can’t be stalled indefinitely. Lots of our private equity cousins are sitting there with money to invest so we know that is likely to come.”
Fundraising data shows European direct lending funds continue to scale, with the average fund size up again in 2022 to $1.5 billion compared with $1.2 billion in 2021, according to Private Debt Investor data. A total of 43 European managers raised $60 billion last year, down from the $83 billion raised for Europe-focused private debt strategies the year before.
Nicolas Nedelec, managing director in private debt at Eurazeo, says that for investors, there is a huge appetite from deal teams for private credit, across all types of institutions. “The deal teams and the allocators understand the merits of the asset class, that these are floating rate instruments and historic default rates and loss rates are low,” he says. “The issue sometimes arises when institutions are subject to broader macro events, such as the now-famous denominator effect, and cause investors to pause but not cancel their decision-making processes.
“Investors are not looking at brand names any more but track record and the quality of deals done in the past. Those without that are going to struggle.”
Cruickshank says things have clearly swung in the favour of LPs in private debt: “The deals getting done are lower leveraged, attracting higher margins, and both GPs and LPs are benefitting from rate increases as well as greater covenant protections.”
But there’s no denying that the market is changing. “With very little public issuance last year and very few CLOs created, a lot of that demand was sucked up by private credit,” says Cruickshank. “LPs didn’t expect those drawdown requests to come through so quickly, and as a result we have seen private credit funds clubbing together on deals. Whilst this isn’t a new feature of the European market, it is becoming significantly more prevalent. That is both a reflection of the pressure on LPs for drawdowns and equally an appetite for spreading risk.”