Ares, the alternative asset manager with $144bn under management, set the pace in 2019 by providing more than £1bn of debt to British telecoms company Daisy in February. Blackstone’s credit division GSO went even larger with the offer of a €1.5bn loan to back Advent’s takeover of Evonik’s acrylic sheet business — although Advent eventually opted for a traditional syndication.
Jumbo loans reflect the credit funds getting larger. This year BlueBay closed a new €6bn fund, while Alcentra, Tikehau and Pemberton followed with respective €5.5bn, €2.2bn and €2bn funds of their own. Ares’ massive €6.5bn fund from 2018 still leads the pack in Europe.
Overall, Europe-based private debt assets grew from €24bn in 2008 to €135bn in 2018, according to data company Preqin.
These entities are “100%” becoming serious rivals to more traditional financing, says Chris Skinner, head of UK debt and capital advisory at Deloitte in London.
“In terms of deployment of capital, European direct lenders are not that far away from the high yield bond market any more. Looking at the first half this year, you are comparing €23bn against €30bn. The size of those deals and target markets are quite different, but the direct lending market is definitely growing faster than any other class in leveraged finance,” he says.
Credit funds can increasingly compete with banks even on pricing, notes Christian Savvides, co-head of debt advisory in Europe at Rothschilds. “The premium for a direct lending solution versus the capital markets solution has narrowed, and the potential deal size has increased significantly. A credit fund solution can be difficult to beat for sectors and deal structures that not everyone in the broader market is going to get on board with.”
He cites retail, construction, automotive and real estate as examples.
In response to the growing competitive threat from private debt, multiple banks — including Citibank, Deutsche Bank and Goldman Sachs — have established their own in-house credit funds. Others have paired up with direct lenders.
“RBS is an interesting example of this in the mid-market, with Hermes, AIG and M&G coming on board as direct lending partners,” Skinner comments.
Credit funds promise a higher degree of privacy and less bureaucracy than their alternatives. For one thing, borrowers are not required to provide financial details to a large group of leveraged loan or high yield bond investors.
“There are lots of borrowers who don’t necessarily want their potentially sensitive trading information circulating around the market,” says Skinner.
A further reason for direct lending’s rapid growth is its certainty of funding. “Borrowers ultimately have a choice — they either want day one lenders, capable of taking and holding the borrower’s debt, or they want an underwritten structure which will be sold into the market. There is a time and place for both approaches, but in their target markets direct lenders have been extremely effective in explaining some of the downsides of the latter — not least flex provisions,” he adds.
Bread & butter
While jumbo deals allow the largest funds to deploy a significant volume of capital in one go, the mid-cap market remains the bread and butter of direct lending.
“We will continue to opportunistically lend to the Daisies of this world, and we have a number of assets in our portfolio to which we have lent north of €500m. That said, we’re absolutely not moving from our core strategy,” says Michael Dennis, co-head of European credit at Ares in London. “By backing middle-market companies and providing additional capital to them as they grow, we are future-proofing deployment opportunities for us.”
The direct lending market is dividing in two, reports Neale Broadhead, head of European private debt at CVC in London. “There are some funds with significant amounts of assets under management who are doing a great job on large-cap deals, going elephant hunting. Then you have other funds like us who are firmly entrenched in the mid-market and quite like remaining there.”
Pemberton, a direct lender backed by Legal & General, does not venture into the large-cap market either. This is to avoid being forced to compromise on loan terms and pricing, as in the currently borrower-friendly syndicated leveraged loan market.
“I’m sure the managers doing large-cap deals are making arguments that they’re getting good terms because they’re providing simpler execution and so forth. But fundamentally we view the large-cap market as a less attractive space,” says Mark Hickey, portfolio manager and one of three founding partners of Pemberton in London.
“The core mid-market space is the most-attractive from a risk/return perspective,” he argues, contending that small companies’ greater vulnerability to financial and operational shocks leads to higher loss rates.
Downturn softening
The next downturn will be the first test of the funds’ resilience. “We talk to our investors about that a lot,” Broadhead says. “We have a big team dedicated to private debt but we also have other analysts across CVC looking at the syndicated loans and a large and successful team looking over credit opportunities and special situations funds. It’s their lifeblood to deal with distressed companies.”
Dennis has seen no “cracks” so far in Ares’s direct lending portfolio in Europe and does not foresee an immediate downturn in the region. However, the firm is preparing for the end of the cycle by making the “vast majority” of its investments in senior secured debt, with covenants giving the lender extra protection.
“We also have a dedicated team of 12 investment professionals whose job is to monitor closely the performance of the portfolio. A lot of our competitors haven’t made that same investment. If assets underperform we have the requisite experience and skill sets to ensure we protect our investors’ capital.”
About a quarter of Pemberton’s mid-market portfolio would have to default annually before investors lose any principal, according to Hickey. He argues strongly for the resilience of direct lending as an asset class.
“I predict this product will outperform all other credit products in a downturn. Most of the public credit is unsecured and covenant-lite, and the losses in those asset classes are going to be huge in the next downturn. We have that downside protection in the form of much stronger credit agreements, and in the meantime, we’re making higher yields and fees on our asset class.”
Nonetheless, Deloitte’s Skinner anticipates harmonisation in private and public debt documentation stripping the funds of extra covenant protection.
“Ten years ago, the high yield market, the US term loan ‘B’ market, the syndicated European loan market and what we now know as the direct lending market were offering relatively distinct products,” says Skinner. “Today harmonisation continues at pace. There is still some way to go, but it would not be that surprising if it were hard to tell the key commercial terms apart over the next five years.”
Jeremy Duffy, partner at White & Case in London agrees. “In order to break into bigger and bigger deals, many direct lenders have had to effectively accept the covenant-lite terms, bring down their pricing and lower their fees. Their pricing is still above the banks’ in general but the documents are becoming more generic,” he reports.
A downturn may offer mega-funds a chance to solidify their position at the top. Those with strong underwriting discipline gained after the 2008 financial crisis, notes Ares’s Dennis.
“We made a couple of acquisitions and consolidated the US direct lending market on the back of the cycle. Something similar might happen in Europe in the next downturn. Winners will become consolidators and the losers consolidated,” he adds.
Already, in Europe, the top 10 private debt managers are raising ever-bigger funds and deploying more capital, leaving only scraps for the remainder.
“The biggest teams can provide the best coverage and expertise to the private equity client base,” Hickey says. “Also, this year about a third of our investments are re-financings or add-on financings for companies that are already in our portfolio. There’s a virtuous circle which brings in more deals the bigger you get.”
Although the idea is untested in Europe, some analysis suggests credit funds may help soften economic downturns. This is because they are incentivised to keep the debt taps flowing in tough economic times, providing their portfolio companies a counter-cyclical source of credit even when banks are turning their backs, a recent study by the University of Pennsylvania’s Wharton School points out.
This model’s catch may prove fatal for weaker funds, however. “Raising committed capital should be a long-term game. Some funds will have problems in their portfolios — plenty of them already do. The question will be how they react,” Deloitte’s Skinner says.
Smaller funds in particular may end up “pouring good money after bad” if one of their limited number of portfolio companies struggles, he adds. And because they are paid based on deployment of their limited partners’ funds, it is in their interest to keep the taps open.
Nor is selling troubled assets viable, comments CVC’s Broadhead. “The sharks would smell the blood a mile away. For an illiquid asset class like that, the price would be devastated,” says Broadhead. “Instead, you need to look after the assets well and choose them carefully. We kiss a lot of frogs before we make our decision.”
CVC reports only lending to 3% of the borrowers it reviews in this area. GC