When the ocean tide ebbs, revealing rock pools scattered along the beach, foragers set to work finding tasty seafood. Europe’s direct-lending market can be described in much the same way. Since 2008 the banks have been deleveraging – withdrawing, like the receding tide, from areas of lending in order to reduce debt-to-equity ratios. This has fuelled the growth of a direct-lending industry – investors that lend to companies without the involvement of banks at any stage in the proceedings.
But foragers on both real and metaphorical beaches beware: some of the would-be morsels may have spikes and sharp claws that could cause painful wounds.
Figures for the size of the direct-lending market are hard to come by for either the US or Europe, because of the private nature of these areas. However, the growth of the European market can be gauged by the increase in the number of direct lenders.
Andrew McCullagh, managing director at HayFin Capital Management, a €6 billion specialist in European mid-market direct lending headquartered in London, estimates that when his firm started in 2009, there were about two or three businesses already involved in the sector. Fast-forward six years, he estimates that there are about 60.
“Private credit has proliferated because there’s a real opportunity,” he adds.
‘VERY STRONG’ DEMAND
For private equity firms asking what the direct-lending market can do for them, the answer is twofold: they can use it to lend or to borrow. Borrowing, on behalf of sponsored companies, offers them speed and flexibility. Several have also set up direct-lending arms in Europe, building on the experience of private equity in the US, where firms such as Blackstone have huge direct-lending divisions.
Private equity firms that do direct lending in Europe include Apollo, which has several billion dollars-worth of loans in the region. Dollar, euro and sterling European loan funds are all common, with the lender making the loan in local currency, and hedging currency fluctuations against the denomination of the fund.
Robert Ruberton, senior portfolio manager and head of European credit at Apollo in London, says that direct lending continues to be fuelled by “very strong” demand from limited partners – mainly sovereign wealth funds, pension funds, insurers and high net worth individuals.
“We’re seeing a thirst for yield across the globe that’s driving a lot of the demand for higher-yielding alternative products like direct-lending funds and credit-opportunity funds,” he says. “I don’t see that slowing down at all.”
General partners also argue that direct-lending funds offer diversification for their limited partners: the returns are dependent on different factors to the returns for private equity, so investors are in effect offered an extra asset class. Furthermore, direct lenders, including arms of private equity firms, often offer a variety of forms of debt to investors, including senior, subordinated and mezzanine.
In common with many direct lenders in Europe, Apollo largely lends to businesses sponsored by private equity, though it never funds companies owned by Apollo’s own PE funds. This policy is typical among private equity firms.
“The direct-lending business is largely driven by private equity funds, since they tend to be the most active borrowers,” says Ruberton.
The presence of a centralised, active market in direct loan deals, conveniently packaged by general partners experienced in getting deals done for their portfolio companies, is likely to reassure potential direct lenders wary of plunging into an area where originating deals may be laborious and complex.
McCullagh notes that Hayfin looks for deals across Europe, using its offices in Amsterdam, Frankfurt, Madrid and Paris. But this is not, he says, the standard model: “A lot of private equity deals flow through the London market, and private equity funds are big users of capital, so if you have a direct-lending fund, you don’t need a big organisation. You can sit in London, and the private equity guys will often come and find you.”
However, the increased ease of entering this market has, in one important respect, made it more challenging: the pricing is less attractive than before because there are so many rival funds.
A senior executive at one direct lender cites the unitranche market – senior and subordinated debt combined into one instrument, usually for a leveraged buyout – as a good benchmark for private credit pricing. He estimates that at the end of 2014, European unitranche deals were 800-900 basis points over Libor. Now, he says, they are in the 700-800 basis point range.
However, direct lenders agree that spreads are still higher than before the credit crunch, when more liberal capital rules often allowed banks to price loans relatively cheaply even if they were riskier or more complex. The rules have since grown stricter under a welter of national and international regulations, including the Basel III banking rules governing the ratio of capital to risk-weighted assets.
In terms of the returns, market participants note that the preferred return for private equity firms’ private debt funds – the return above which the manager earns an incentive fee – has come down from 8 percent, the same as the typical rate for private equity funds, to 6-7 percent in the case of many funds that make senior secured loans.
Direct lenders justify this lower rate for the safer parts of the private debt market by arguing that it is less risky than private equity. Some also argue that it is unlikely to go lower.
“Six or 7 percent – equivalent to Libor plus 500 basis points or so – is a natural floor for the direct-lending market,” says one senior figure in the industry. He reasons that at rates below that, the debt would be priced too cheaply. Because of this, “I think people are holding that level constant”.
The increased competition also forces direct lenders to work harder to find good deals.
“A lot of people have got into direct lending, whether traditional private equity sponsors or dedicated private lending platforms,” says Gus Black, partner and specialist in investment funds at Dechert, the law firm, in London.
“So the issue becomes: how do the lenders differentiate, and who’s prepared to seek out the rich seams of opportunity, as opposed to the more crowded ones?”
As an example of a potentially rich, less populated seam, he cites unsponsored lending, where no private equity firm is backing the borrower: “It’s harder to do, because a lot of the work that would be done by the private equity firm has to be done by the lenders.”
McCullagh of HayFin cites one seam that is relatively untapped: rescue finance. McCullagh says that rescue finance is sometimes used for retailers in the throes of commercial turnaround, which do not generate cashflow or EBITDA on a net basis.
This makes raising finance from the banks hard, he says. Their redeeming characteristic, often, is their large amount of assets, such as stock – but using these assets as security is a complicated business. As a result, “it might take six months to put a loan in place”.
This complexity produces its own reward, however: what McCullagh describes as a “return on effort” premium. HayFin recently lent to a large German retailer on this basis.
Another rich seam, say some lenders, is cross-border lending. The banks have deleveraged largely by withdrawing from foreign markets and concentrating on home territory. Observers say that as a result, loans involving more than one country are often difficult for borrowers to source.
The previously mentioned senior executive at the direct lender gives the example of a prospering family-owned manufacturer which approached it back in 2013. It was, as he puts it politely, “in one of the more challenged countries of Europe” – a black mark as far as banks are concerned. It also wanted to buy a key supplier, also financially healthy, in another country.
“Because the company was in a different jurisdiction, it was difficult to get traction from the traditional bank market,” he notes. The direct lender made a five-year loan, which has since been repaid in full.
A further way for direct lenders to achieve high rates in the face of stiffer competition is to go for riskier deals, by lending to highly-leveraged companies.
“I’ve seen how leverage has gone up over the past six years, as we enter the later stages of the credit cycle,” says Callum Bell, who as head of corporate and acquisition finance at Investec in London acts as a direct lender. Debt-to-EBITDA ratios of LBOs have risen from a trough of just under four in 2009 to almost five for the first three quarters of 2015, according to S&P Capital IQ, the information provider.
Could high leverage generate defaults? Defaults are still low in Europe, whether for loans made by banks or by direct lenders.
Bell warns, however, that if an economic downturn affects their corporate cash flow, “the interesting area for defaults will be at the smaller end of the market, right in the heartland of direct credit: businesses with an EBITDA of €10 million or slightly lower”.
He thinks that direct lenders are vulnerable for another reason: “Banks have gained quite a lot of experience over the last 15 or 20 years about what works and what doesn’t, but the direct funds just don’t have that experience, so they will make mistakes. That’s what will happen, with an industry that’s only been around for five or six years.”
But although the flood of capital is, by increasing competition, potentially making life harder for direct lenders, it is making life easier for the borrowers – including businesses sponsored by private equity funds.
“There are a lot of advantages to using direct lenders,” says Alan Davies, who, as corporate partner in the European Finance Group of Debevoise & Plimpton, the law firm, mainly advises private equity sponsors. “Clients aren’t exposed to the risks of syndication, as they are with bank deals. Also, it’s a very private market, so everything can be kept confidential. Some of our clients will pay a premium for all this.”
Explaining the hazards of syndication, Davies cites the risks that terms agreed at the outset are redrawn at the behest of lenders in the pool, and that the bank might raise rates in the weeks or months after the syndication deal is signed, as it can often do under the “pricing flex” terms of syndication deals.
A further disadvantage of syndicated deals, says Davies, is that they tend to be set on certain standardised terms in order to secure the agreement of a host of potential lenders. A one-to-one deal agreed between a direct lender and a borrower can be more customised. For example, the borrower might want to pay interest on subordinated debt entirely in principal and not at all in cash – paying it at the end of the loan rather than in a steady stream over the loan’s life. The loans are, to put it another way, less commoditised.
“Direct lenders may sometimes be more expensive,” says Davies. “But it’s not all about who can provide the cheapest money.”