Taking the stage: Direct lending market in Europe
It's safe to say Europe's direct lending has stepped out from the shadow of its older, more established US cousin. And the stage is set for the market to grow bigger and faster.
Europe's direct lending market took some time to get going, but last year the region firmly planted its flag in the ground. In April, Ares Management, the Los Angeles-based fund manager, secured a final close of EUR11 billion for its fifth European private debt fund. The vehicle is not only a record haul for Ares and the region; it is among the largest debt funds ever raised on the international stage.
Ares and its peers will not be sitting idle, either. Europe has been later out of the gate than the US. However, since the financial crisis, direct lenders across the continent have stepped in to fill the supply gap left by a heavily regulated and less risk-tolerant banking sector, the industry steadily chipping away at traditional lenders' market share year after year.
The initial lockdown period in 2020 notwithstanding, COVID-19 has done nothing to derail a trend that has now been in motion for more than a decade. Many banks had their bandwidths constrained administering state-backed loans and have tightened their underwriting criteria, wary of sectors that have been hit hard by the pandemic. These have been ideal conditions for private lenders to flourish.
And that's precisely what they have done. Following a quiet start to 2020 and under pressure to deploy, direct lenders in Europe went on a veritable dealmaking spree in 2021. By the time a record-breaking Q3 came to a close, there had been 549 deals, already besting full-year 2019.
Spreading its wings
A number of underlying factors are behind this burst of activity. One is the widening scope of direct lending. "We are seeing the European market catch up in size and direct lender penetration as the de-banking trend continues. We have also seen convergence between the direct lending and liquid capital markets accelerate in Europe, with larger companies seeking private capital solutions," says Blair Jacobson, partner and co-head of European credit for Ares Management. 'This trend had previously been more prevalent in the US."
Private debt funds continue to encroach further into territory that used to be the preserve of the syndicated loan and high-yield bond markets. Not only are funds growing in size, but they are increasingly comfortable collaborating, thereby scaling up their deployment capacity.
'We worked on a number of deals in 2021 with particularly desirable assets where lender competition was fierce" says Neil Campbell, a partner in DLA Piper's debt finance practice in London. "Whilst our experience generally is that private credit would still prefer to hold the whole investment, sometimes sponsors will say to a lender we're very happy to have you in the deal but we'd like to partner you with another fund; private credit will typically prefer to deploy some capital rather than none, and then the sponsor will potentially have access to huge pools of capital for follow-on funding."
"Another major catalyst has been the unprecedented urgency among PE funds to return to the dealmaking trail. Pent-up demand from firms sitting on significant dry powder combined with an accelerating economic recovery created strong market tailwinds and led to a likely record volume of transactions completed in Europe in 2021."
-Blair Jacobson, Partner and Co-head of European Credit, Ares Management
Another major catalyst has been the unprecedented urgency among PE funds to return to the dealmaking trail, says Jacobson. "Pent-up demand from firms sitting on significant dry powder combined with an accelerating economic recovery created strong market tailwinds and led to a likely record volume of transactions completed in Europe in 2021."
Direct loans made to mid-market companies are typically used to finance leveraged buyouts, bolt-ons and refinancings and help financial sponsors take risk off the table by paying their investors dividend recapitalisations.
After sitting on the sidelines through the first half of 2020, GPs have been making up for lost time. The wider EMEA region saw USD318 billion worth of PE fund capital deployed through 2021 - almost double the previous year's total, and the highest annual value on record. And it's increasingly common to see these equity funds turning to debt funds for their acquisition financing needs.
"There's been a steady march of direct lenders taking the banks' market share. As the amount of capital raised increases, you're seeing more competitive tension in the market in Europe; therefore the pricing differential for the credit funds continues to fall. But you're still getting the flexibility, the extra turns of leverage, fewer covenants and controls. That makes it an even more attractive proposition for sponsors and borrowers."
-Matthew Christmas, DLA Piper Partner, London
Cut to the chase
The inherent challenges of the pandemic also play to the strengths of direct lenders in a number of ways. In today's unsteady environment, financial sponsors want speed and certainty of execution. With the ebb and flow of infection rates, lockdowns and trading performance, timing is everything. Unlike sometimes slow-moving banks, or temperamental public debt markets, funds are fleet of foot and can make quick underwriting decisions.
Whilst bank lenders continue to try to come up with strategies to be able to compete with private credit in terms of overall leverage across the structure, having a nimble institution with easy access to the investment committee, strong deliverability and speed of execution is at times an advantage versus bank lending.
While the pandemic is showing positive signs of abating and economic growth is stabilising, risks remain. Central banks have a firm eye on inflation. The Bank of England raised its base rate to 0.5% in January and the European Central Bank anticipates a similar move in early 2023. Businesses will have to balance the potential for rising costs to erode their earnings amid continuing inflation, while forecasting any increase in financing costs as rates rise.
Having an understanding and active lender that's prepared to negotiate covenants in this more hawkish environment will be a major boon. And with PE loaded to the hilt with capital, there will be no shortage of private lending demand in Europe through 2022.