Direct lending has grown into a go-to funding source for mid-cap corporates in Europe. Though all-in margins are often wider than bank debt for borrowers, the terms are much less restrictive. Companies can expect the lender to be more flexible and potentially offer more capital down the line.
European direct lenders typically manage the capital of institutional investors such as pension funds and sovereign wealth funds, with firepower totalling around $150bn.
There is nothing preventing these investors from being pro-active when understanding a fund’s investment strategy. They typically have access to loan agreements between borrower and lender, and can probe the fund as to why it makes specific investment decisions. But several sources have told GlobalCapital that LPs' oversight of their investments can often be quite sparse.
One fund manager used colourful language to describe the process through which certain LPs decide which funds to invest in, calling them "dumb money" for basing investment commitments on somewhat cursory questionnaires.
As the market heats up, competition between funds for deals is growing fierce. Margins are tightening to accommodate the borrowers, and covenants are being shed. Without the watchful eye of LPs, funds are under less obligation to stay out of riskier investments.
LPs could be forgiven for relaxing as the market notches up high single digit returns in such a painfully low interest rate environment. But if the market turns and certain funds fall into difficulty through risky lending, it will be the LPs left holding the bag.