Direct lending funds discover banks are not giving up easily
2015 was meant to be the year that direct lenders conquered all before them, as banks’ retreat from mid-market lending became a rout. But the opposite has happened. Despite the enormous weight of money pouring into funds, banks are still there, and funds are having to deal with it. Ross Lancaster reports.
Direct lending was a fairly straightforward pitch in the first years after the financial crisis. As banks stopped lending to mid-market companies, funds would step in and take the returns on offer.
Some observers were always sceptical of that narrative. But 2015 was the year when it became clear the alternative lending story did not play out that way. Banks have kept a central position in mid-market finance and the space’s complexity is only set to increase.
“While a number of banks have pulled out of the mid-market space entirely — notably GE Capital — it is fair to say that European commercial banks remain an important part of the European mid-market and we expect them to remain important for the foreseeable future,” says Max Mitchell, head of direct lending at Intermediate Capital Group, the leveraged and mezzanine finance investor, in London.
In 2014, it was already evident that banks were determined to stick it out in the mid-market. Back then the story was of banks’ competitive pricing pitched against the looser term sheets offered by funds.
But as 2016 got under way, banks’ role in the mid-market is not limited to being the heavy hitting competition. Many direct lending funds will have to seek partnerships with banks in order to put their money to work.
“Non-bank lenders need to have a business model that allows them to both compete effectively against the banks, but also, on certain deals, to work effectively with them,” says Mitchell, “either on a deal-by-deal basis or through more structured partnerships.”
Bluntly, lending opportunities have not matched the enormous amount of money flowing into direct lending funds. Those that are putting capital to work have often had to move away from the original game plan of picking up business abandoned by the banks.
“It takes a long time to build the necessary mid-market relationships and put money to work within the direct lending space,” says Stuart Moon, head of loan sales and distribution at Lloyds Bank in London. “So many funds are targeting the big commercial banks and offering to partner up with them.”
“There has been a real shift in the market,” says Mathieu Chabran, managing director and chief investment officer at Tikehau, the private debt investment firm. “Today, direct lending funds get involved in syndication, they get involved in bonds. The boundaries are falling and private debt is really about being a credit investor with long term liabilities.”
Chabran adds: “Every day there is an announcement of a new credit fund coming to market, but most of us work with banks. Banks are back in the game and are looking to offload paper, so more and more credit funds are working with banks in a quasi-club mode. That doesn’t provide huge added value, but because there’s been so much money raised, some have to.”
But even to partner with banks will require sharp elbows for funds jostling to win borrower relationships.
“Banks are still keen to lend within their own backyards, and it remains an ultra-competitive market, with everyone still looking to provide balance sheet to the same companies,” says Moon. “It’s when a bank exits a relationship with a borrower that a direct lender can come in as a partner with another bank, or alternatively when the borrowing needs outstrips the incumbent bank’s appetite.”
The problem with getting a grip on private debt is that the industry is as varied as the public markets that compete with it. Borrowers range from UK SMEs seeking a £5m loan to Formula 1, which placed a $1bn high yield loan with private investors in 2012. And just as the size of private debt tickets varies, so does the way investors work with banks. At both the extreme ends of deal size, though, few see a future without banks.
David Allen is managing director, principal credit investment at the Canada Pension Plan Investment Board in London, which provided $400m of the Formula 1 loan.
Allen’s team will take tickets in bank underwritten loans, but also engages in direct, solo loans, where it negotiates a term sheet with the borrower and prices the deal.
Some of these transactions are brought to CPPIB by banks, others it finds itself — but in both cases, it often pays banks a fee, just to keep the banks keen to bring it deals.
“On sourcing deals, we do a lot ourselves but are also looking for partners — banks, advisers and through our network,” says Allen. “I focus on building partnerships and this leads to better proprietary dealflow. And we try to share economics with our partners, because it makes sense for long term relationships.”
Allen adds: “For example, on a 10 year deal, a one [percentage] point upfront fee translates into 10bp a year, so a 10.25% deal becomes 10.15%. But what drives our returns is low defaults and positive convexity on successful investments. About half our long term returns come from coupons and the other half through price appreciation.
“I always take a long term view with our partners, so we get access to greater dealflow in the long run.”
At the other end of the spectrum is Paul Shea, partner at Beechbrook Capital, which provides £5m-£10m tickets to UK SMEs. But his attitude to banks is similar to Allen’s.
“We have a positive view on the banks: institutions like RBS and Lloyds really want to look after their SME customers,” says Shea. “They want to keep them and get them the right financing solution. But they have a desire to provide only certain products, such as bank accounts, overdrafts, asset-backed lending and maybe some FX. So, low capital-intensity, fee-driven business. A lot of them provide standard products in large amounts.
“What is less attractive to the banks is £5m-£10m cashflow term loans to SMEs: it requires more resource, risk and capital,” he says. “So we actually see an interesting opportunity to partner up, with the banks providing those services and us providing the term loans.”
The bubble that never burst?
In the first half of 2015, there was much talk in leveraged finance circles about whether direct lending was becoming a bubble.
As Chabran says, new funds were cropping up almost daily. Many of them were being launched by large asset managers and private equity firms.
“Ten years ago or so, a number of the major funds did not have credit arms, and now they do,” says Mark Donald, head of the London banking practice at Weil, Gotshal & Manges. “A number of the largest multi-asset managers have been hiring specialists to do direct lending. My prediction will be: continued new entrants, and increased diversification from single play asset managers to more varied strategies.”
New players are not just arriving from established investment firms. There is an irony that, for all the talk of banks quitting mid-market lending, many new direct lending fund managers have been arriving fresh from banks.
Many of these ex-bankers are tired of spending ever-mounting hours ticking regulatory forms. Participants say bank pay in leveraged finance has fallen or stagnated, while the buy side is doing handsomely.
“Bankers are two-a-penny these days,” says one City headhunter. “We’ve lost count of the amount of their CVs coming across our desks trying to find a home in direct lending.”
Keeping count of direct lending falls firmly into a list marked ‘industry challenges’. The sector is chary of publicity, and how do you define it anyway?
Finding definitive data is impossible. Preqin estimates that European private debt funds increased their dry powder by 66% to $61bn between December 2014 and November 2015 — though this includes mezzanine, special situations and distressed debt funds as well as direct lenders.
The figures are disputed, but few doubt that as the market increases in complexity and competition, some players are likely to get squeezed out.
“Preqin reports that there are 85 direct lending funds trying to raise capital in Europe, however a lot of this is noise,” says Mitchell at ICG. “The successful fundraises are much fewer. LPs are becoming very discerning about which managers they give capital to in this space.”
He adds: “We note that even having a big brand name from the hedge fund or PE world is not a guarantee of success. We see teams that have been on the road for over two years and still haven’t had a first close on a fund.”