The universe keeps expanding

Private debt funds’ share of buyout market financing has continued to climb, although they are likely to hit the ceiling eventually.

The march of private debt funds in Europe continues. Perhaps the most remarkable example is Germany where, four or five years ago, funds were simply not on the radar when it came to providing debt finance for the country’s leveraged buyout market. Yet the latest MidCap Monitor from investment bank GCA Altium, published this week, showed that funds now make up more than a 50 percent share.

In Europe as a whole, credit funds provide around 40 percent of debt financing for private equity deals, compared with 60 percent for the banks (an admittedly rough approximation culled from market sources). The funds’ share grab began in the aftermath of the global financial crisis and, for around five years, no one was particularly surprised by this growth as the banks remained on their knees.

But from around 2014, with the banks’ balance sheets showing signs of recovery, talk began to turn to two possibilities: either the banks would fight back and reclaim some of that lost share; or, at the very least, private debt funds would find they had hit the ceiling in terms of their European growth potential.

In fact, neither happened. The newcomers kept on upstaging the incumbents.

One reason why was the lag between the banks beginning to shrug off the burdens of the past and being ready to move full steam ahead. Regulatory restrictions on the banks’ lending activities have played a significant role in their decision to apply the brakes. It may well have been the case that balance sheets were recovering nicely in 2014, but it wasn’t until last year that many aspects of the punitive Basel III regulations were finally implemented.

There were other reasons why debt funds kept on growing. One charitable explanation is that funds provided the types of product that borrowers concluded they couldn’t do without, offering greater flexibility than the banks were typically able to in terms of structuring and speed of delivery. Less charitable is the argument that debt funds were way too flexible in a crazy market and that the banks were quite happy to reduce their exposure. Either way, the net effect was the same – the continuing advance of the funds.

Will it continue indefinitely? The smart money is that there is indeed a limit to how much further the fund universe can expand – at least in the context of the private equity-sponsored universe. Because it’s the quickest way to reach profitability (you don’t need a deep bench to do private equity-sponsored transactions) and the easiest way of doing deals (thanks to the excellent due diligence reports that come gift-wrapped), this part of the market is intensely competitive.

The strains on the system that this competition has produced will undoubtedly become clear when the next downturn strikes. The benefits of diversifying outside the private equity market will then be evident, though this lesson may come too late for those who have become over-reliant on it.

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