The journey continues: The future of direct lending

Europe's direct lending market has come an awful long way over the past decade, and yet has so much more room to grow.

Direct lending is becoming mainstream but forecasts show it could become commonplace. Oxford University's Said Business School has estimated that assets under management (AUM) may rise by up to 50% in the medium term if market penetration grows in line with current levels seen in the US, measured by AUM as a percentage of GDP.

There is plenty more gas left in the tank for direct lending worldwide, too. By one estimate, global AUM is projected to grow by 11% per annum through 2025, according to Preqin, Europe having an increasingly sizeable participation.

In the persistently depressed interest rate environment of the past decade and counting, public credit markets simply have not offered the returns that investors need to meet their targets. As funds have increasingly taken market share from banks and more recently the smaller end of the syndicated loan and high-yield bond markets, investors have become familiar with investing into private funds as part of their broader credit strategies, drawn to the illiquidity premia they have to offer over public debt capital markets.

"The rising rate environment is ultimately beneficial to folks who are originating a floating-rate product like direct lending loans. That product will continue to be very attractive on the LP fund investor side because those funds have demonstrated healthy returns, even in the essentially zero-rate environment of the last two years."

- Jamie Knox, DLA Piper Partner, New York

Policy shift

The threat of COVID-19 shows early signs of abating and as economies normalise from the shock of the pandemic, central banks are tightening monetary policy to curb runaway inflation. This also holds promise for the asset class.

Unlike fixed-rate bonds, private debt funds' loans float at a spread above an agreed benchmark rate like synthetic LIBOR and, increasingly, SOFR and SONIA. This means investor returns will not be chewed up by rates as central banks adjust their compasses in 2022 onwards.

"The rising rate environment is ultimately beneficial to folks who are originating a floating-rate product like direct lending loans. That product will continue to be very attractive on the LP fund investor side because those funds have demonstrated healthy returns, even in the essentially zero-rate environment of the last two years," says Jamie Knox, partner in DLA Piper's debt finance practice in New York. 'When you add on increases in the underlying benchmark rates, that looks very interesting to LPs. You should see continuing success on the private debt fundraising side."

Other advantages include call protections and prepayment penalties. From an investor perspective, direct lending funds offer compelling opportunities, albeit with a caveat. Manager selection will continue to be paramount and will need to be matched to investors' risk appetite.

Even in worst case scenarios, however, investors benefit from the fact that direct lenders are responsive, hands-on managers. "Often direct lenders can be more nimble and more creative about responding to an unexpected situation, provided they have the bandwidth and resources, as many are also quite lean teams," says Knox.

Not only do they tend to have greater flexibility in offering covenant waivers or providing liquidity support, which is great for borrowers, they often have in-house experience of managing out positions if push comes to shove and there is no residual value left in a company's equity, prompting a forced restructuring. In these rare instances, direct lenders can be better at preserving value than banks. These are all major pluses for investors.

Appetite for capital

On the demand-side, a major driver is the wall of PE dry powder in the ecosystem. Globally, buyout funds were sitting on USD1.32 trillion of undeployed capital as of September 2021, Preqin estimates. And direct loans are becoming an increasingly popular counterpart to this LBO equity. According to S&P, in Q42020 as much as 88% of European mid-market loans came from direct funds, 80% of which were used for acquisitions, the remainder earmarked for refinancings and general purposes.

"We entered this year with a robust deal pipeline and expect transaction volumes to continue at the current pace throughout the year. We anticipate demand remaining robust for direct lending capital to fund PE buy-and-build opportunities, and also to help complete public-to-private deals," says Jacobson. "Further, we look forward to the continued integration of ESG best practices in the investment processes of direct lenders, as well as the continued maturation of sustainability-linked loans."

Cognisant of the opportunity and their eroded market share, banks have begun to push back. Last year, HSBC Asset Management launched a UK-focused direct lending investment capability in partnership with HSBC UK, targeting private equity-backed mid-market borrowers with EBITDA of between GBP5 million and GBP50 million.

"We anticipate demand remaining robust for direct lending capital to fund PE buy-and-build opportunities, and also to help complete public-to-private deals. Further, we look forward to the continued integration of ESG best practices in the investment processes of direct lenders, as well as the continued maturation of sustainability-linked loans."

- Blair Jacobson, Partner and Co-Head of European credit, Ares Management.

Collaborative spirit

There has also been a meeting of minds between the competition. "Over the past two or three years, you can see more collaboration between direct lenders and banks. Banks are more comfortable doing this and are also more familiar with the capital structures being designed as well as the names and faces of the advisors and lawyers," says Juan Gelabert, partner in DLA Piper's debt finance practice in Madrid. "It's good for both sides, but sponsors are the real winners because they have access to a wide array of financing options."

Even where the two sides are not in collaboration, in many instances sponsors continue to sound out both banks and direct lenders and decide who to go with depending on their specific needs. After all, bank loans tend to be cheaper.

"Over the past two or three years, you can see more collaboration between direct lenders and banks... It's good for both sides, but sponsors are the real winners because they have access to a wide array of financing options."

-Juan Gelabert, DLA Piper Partner, Madrid

However, the numerous advantages of direct lending are in harmony with the requirements of leveraged dealmakers. Buyout targets and their new PE owners typically have more elbow room to customise borrowing terms when negotiating private loans. This can result in looser borrowing covenants, greater flexibility on terms and, crucially, extra turns of leverage.

Covering the cost

This is a critical advantage in today's pricing environment. Unquote estimates that the average EBITDA multiple paid in Europe in Q3 2021 reached a new high of 12.4x, up to as much as 14.3x for technology-related assets. Putting more debt in to the capital structure rather than covering these high entry prices with more equity is highly attractive to sponsors as their returns come under pressure.

These advantages augur well in an environment in which PE funds are loaded with capital and under pressure to deploy in order to evenly spread their vintage risk. "With all of the dynamics of having huge amounts of capital that still needs to be deployed and people frankly not being able to do anything other than work during parts of 2021, that has contributed to a lot of activity in both private equity and private credit," says Campbell. "In spite of the slightly softer start to 2022 vs 2021, those factors haven't fundamentally changed... although I'm personally pretty pleased that we can now socialise more!"

Ultimately, one simple equation spells out where Europe's direct lending market is heading: private equity deal flow is at elevated levels and banks have a smaller share of the term loan market that backs these deals than ever before. There is still plenty of room for growth.