This article is sponsored by Tikehau Capital
One of the surprises of the pandemic has been the resilience of the European direct lending market. In a recent white paper “European Direct Lending – Delivering Through the Crisis,” Cécile Lévi, head of private debt at Tikehau Capital, and Joss Trout, head of the investment specialists group, discuss why the asset class came through its first real test so well. Private Debt Investor caught up with them to discover their thoughts on the state of the market in 2021.
How did direct lending’s growth in Europe prepare the asset class for covid-19?
Joss Trout: Direct lending has grown rapidly in Europe since the global financial crisis, which is the real starting point because of dramatic changes in the banking sector. That drove the emergence of institutional alternative lenders, whose role has matured into one of systemic importance to the financing of mid-market companies.
In recent years, we have seen rapid growth of global private debt AUM, from around $275 billion in 2009 to over $850 billion (€240 billion in Europe) in 2019, with direct lending activity representing the largest segment. It has also created an investable asset class that is providing stable real returns to global savings pools as an alternative to traditional public debt.
Direct lending was therefore well-positioned going into the crisis, notwithstanding some emerging late-cycle concerns about how it might withstand a downturn.
What were the biggest concerns facing investors and managers about resilience?
Cécile Lévi: The biggest concern was that the asset class had not been tested, so it was uncertain whether companies under private equity and private debt ownership would be able to deliver to high expectations. Companies were under pressure to be more digital, more international and so on, and there were questions over whether managers had selected strong, performing companies. In our portfolio, our investment thesis included avoiding too many companies with consumer-related revenues, so we have not seen much major impact related to the immediate stop of operations.
JT: One of the misconceptions was that, in the event of a downturn, direct lending portfolios would be severely impacted because there was not enough diversification to provide resilience, with too much focus on mid-market companies and local markets. In fact, when you look at mid-market companies that managers have focused on, they are often very diversified geographically in terms of operations, scale and sectors.
How did European direct lending respond to the pandemic, and what were the biggest market challenges?
CL: It caused a major disruption to the way we operate and we learned that companies under private equity ownership, with this type of financing, are quick to react. In a matter of weeks everyone was able to move to remote working, to assess key priorities and take necessary initiatives.
We wanted to make sure we had the right flow of information, the ability to connect with companies, and that everything was either under control or at least problems were identified. Our international exposure proved a big support to our companies, because on the back of what we were seeing in Asia we were able to warn management teams ahead of the curve. We put together a directory of all our companies to enable them to reach out to each other.
There was also much more frequent contact with investors, who wanted regular updates. Direct lenders are known to be flexible and fast, and we reacted to the flow of requests from companies focused on the preservation of liquidity by setting up a dedicated investment committee. We also had many companies bringing us acquisition opportunities – we were extremely supportive.
JT: The allocation of state-backed loans has been substantially pre-emptive. Looking across our portfolio, the cash that has been drawn down is largely sitting on balance sheets. In many cases, the amount of cash that portfolio companies are now holding is close to normalised levels of annual EBITDA before the crisis hit.
As we enter 2021, what is the outlook for fund returns now, and why?
CL: Since Q3, activity levels have been extremely high, with many new situations on a global basis. Some industries identified as being resilient or at least not showing a sharp decline have seen a lot of private equity activity and competition. We have not seen a major repricing on the back of this, and with interest rates expected to remain low, private debt returns to investors remain attractive. From a risk-returns perspective, global leverage levels should be slightly lower than they were pre-covid.
JT: Short term, we may see some sharp markdowns in certain sectors, but those should be moderated by lower historical exposure to cyclicals and multi-dimensional diversification. Longer term, the impact on returns for well-managed funds will likely be quite small; direct lending will not experience a paradigm shift.
Given the scale of dry powder, where do you expect deal activity for direct lenders going forward?
CL: Private debt may be directed more towards special opportunities and distressed situations. In direct lending, the focus will be on covid-resilient sectors, like IT consulting, software, B2B services, financial services, insurance and anything related to healthcare. Those sectors were already getting a lot of attention, which has been amplified.
JT: Private debt dry powder has increased because that includes distressed and special situations, but direct lending dry powder is not out of line with normal levels. Fundraising was also significantly reduced in 2020, and again focused on distressed, so we don’t see it as a concern given the strong secular growth in demand for financing.
Finally, what do you see as the key learnings for investors in direct lending?
CL: This asset class is a long-term investment: loan facilities are still in place and nothing disappears overnight, while the difference between low interest rates and what we can extract is attractive. Valuations of companies have not declined and on the contrary we can highlight some inflation in asset prices, so overall loan-to-value is still quite strong, which means from an investor perspective the asset class has been shown to be extremely resilient.
Companies supported by private equity and private debt have proven to be well-organised and agile, with courageous and energetic management teams. We address companies that are already material, cash-positive, with strong cashflows – small enough to be agile and not too big to be destabilised by successive lockdown measures.
JT: The benefits of diversification, the need for a good origination pipeline, and lending discipline are important. Even before the pandemic, we had been anticipating a downturn. When it hit, lending decisions taken previously were so important – we had been using a downturn in demand as a base case to inform leverage multiples and other key lending terms. Having those mitigants in place has been significant.