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Direct lenders aim higher as fundraising ramps up

Shooting birds

Private credit funds in Europe are increasingly sizing up larger companies that would have otherwise been candidates for the high yield and leveraged loan markets. The challenge for the private debt market, reports Silas Brown, will be whether it can keep its discipline during its sharp rise

Private credit funds never used to worry leveraged finance bankers and investors in high yield bonds and leveraged loans. In fact, as direct lenders focused on lending to the middle-market, investment banks were happy to cede them ground as regulatory constraints restricted the banks from holding too much middle-market debt.

But the situation is changing. A number of portfolio managers from institutions like Ares, Blackstone Credit, Goldman Sachs AM, HPS and KKR are eyeing up the traditional stomping ground of the high yield bond and leveraged loan markets. Certain direct lenders are looking at €1bn-plus deals, either on a sole basis or in a small club together.

“There are tanks on our lawn,” says a senior levfin banker in London. “Direct lenders have strong access to private equity firms and can stomach certain things the high yield and leveraged loan market simply cannot. This makes them competitive for at least some of our flow, which is concerning.”

European private credit has proven resilient in its first big credit test. Through the coronavirus pandemic, there were only a few cases of default or debt-for-equity swaps.

“There were difficulties with high street and retail,” says one debt advisor in London, who points to UK names such as Debenhams, New Look and Paperchase. “But beyond that, fund managers showed they had discipline when choosing which sectors to lend to, but also that they could open their cheque books and be flexible to further help companies they had lent to.”

More and more investors are deploying capital into the asset class, in part because of the resilience the market has demonstrated.

According to Preqin, the first half of 2021 marked the best fundraising conditions ever recorded by the data provider.

Globally, private debt managers raised $87bn in that period across 108 funds, compared with around $75bn the year before.

One of them, Ares, raised a record €11bn for its new European direct lending fund in 2021. As of March 2021, there was almost $450bn of assets under management in direct lending funds across the world.

Blair Jacobson

The sharp growth means some private debt funds are now able to offer €1bn-plus on their own. Ares, for example, provided UK environmental services firm RSK with a £1bn sustainability-linked unitranche deal this summer.

“As our capital base has grown, we have become more relevant to larger borrowers who are willing to pay a premium for the benefits of a private credit solution,” says Blair Jacobson, co-head of European Credit at Ares, who highlights the certainty and ease of execution, the ability to tap undrawn facilities as well as confidentiality. “As such, our addressable market has expanded to companies seeking up to €1bn-plus of total debt facilities, demonstrated by the recent investments in Ardonagh, TalkTalk and Morrisons, amongst others.”

Observers expect more €1bn-plus deals to come into the direct lending market, particularly if direct lenders start collaborating with each other to reach those figures.

For example, in November global wealth management platform FNZ eschewed the public markets and raised £1.5bn in a unitranche deal with four direct lenders. HPS, the anchor investor, was joined by Arcmont, Hayfin and Goldman Sachs on the deal. “We’ve seen this sort of collaboration in the US already, and the best way of knowing what will happen in European direct lending is by looking across the Atlantic,” adds the adviser. “To compete with bank-led leveraged loans and high yield for those €500m-plus deals, having a small club of lenders joining the deal really helps.”

Comparative strengths

But it takes a strong magnet to draw companies away from the leveraged loan and high yield markets, which have robust investor bases and offer lower rated companies historically cheap funding. Moreover, investment banks generate a good chunk of revenues from fees related to underwriting these deals. Unlike the paltry scraps of fees from middle-market lending, the banks are loath to give the large-cap deals up.

Direct lenders expect a pricing premium over public markets as the debt they hold is less tradeable and therefore riskier. Leveraged buy-outs for straightforward sub-investment grade credits can price as tight as 350bp over Euribor in high yield and leveraged loans, which is at least 150bp inside what the direct lending market can achieve.

To attract companies with access to the public markets, private credit managers must play on other facets beyond mere pricing. Funds position themselves as long term lending partners. For certain credits with a buy-and-build strategy, this pitch is enticing.

“Sponsors are attracted by the private nature of the direct lending deal, lack of flex, and no requirement for distribution or a public rating,” says Symon Drake-Brockman, managing partner of Pemberton.

Private credit funds can also be more forgiving about high leverage. Blackstone Credit and Macquarie provided a €320m cov-light unitranche loan to fund Blackstone’s acquisition of Belgian filter maker Desotec, which came in at roughly eight times the company’s Ebitda of €40m. Though this amount of leverage is rare, for the right credits direct lenders can get comfortable with it.

“Private credit can take the weird and wonderful from our markets, meaning things with high leverage or something complicated about them,” says the levfin banker, adding that ratings agencies and leveraged finance investors would take a stern view of companies that are eight or nine times leveraged. “But for straightforward double-B euro names, direct lenders may struggle to get much traction as high yield and leveraged loans are too cheap, too quick and for those sorts of names there’s very limited execution risk.”

Eyes on sterling

A way that direct lenders have forced themselves into larger cap lending is by focusing on smaller or less liquid funding currencies that euros. Direct lenders have pinpointed sterling as a potential opportunity for growth. This emphasis on sterling deals makes instinctive sense, as direct lending first emerged in the US, and the majority of funds are located in London.

“UK banks were heavily impacted by the global financial crisis and subsequent regulation, which fuelled growth of the asset class and market share of direct lenders,” says Jacobson. “We have seen an uptick in private credit demand from larger borrowers, due in part to the lack of sterling liquidity in the capital markets. We also observed a surge in public-to-private activity involving private credit providers given the advantages that we can bring to these transactions including certainty of deliverability and confidentiality.”

The sterling market does not have the depth of investors that the euro market has, so companies take more execution risk issuing.

Drake-Brockman tells GlobalCapital that the UK economy has a high proportion of defensive, asset-light, high free cashflow companies in healthcare, software, and technology which are frequent targets of private equity firms. “The UK private credit market has been, and continues to provide, the largest and most mature market for direct lending in Europe,” he says. “In terms of LBO volume, the market has rebounded strongly from a Covid-related slowdown driven by the UK’s early adoption of an aggressive vaccination strategy. The market has also largely shrugged off any Brexit related issues.”

Cov-light concerns

But as the market heats up, traditional protections it used to have are being shed. Historically, most deals in European direct lending carried covenants on interest coverage, net leverage and capital expenditure. Over the years protections around interest cover and capital expenditure have been tossed aside with only net leverage covenants remaining.

But driven particularly by Blackstone Credit and Goldman Sachs AM among others, the market may be moving one step further. Certain direct lending deals are now being signed on a cov-lite basis. According to markets sources, Goldman Sachs AM provided a €500m cov-light unitranche to French pharmaceutical firm HTL Biotechnology in November, to back its buy-out by private equity firm Montagu.

“Covenant-lite deals in the private credit market have always featured for a small number of transactions,” says Drake-Brockman. “Historically, they have been mostly used in larger deals where a private market alternative to a covenant-lite syndicated loan is required. These deals range from €400m to €1bn-plus.

Symon Drake-Brockman

“Our expectation is that the vast majority of deals in the core mid-market space will be covenanted, but in the larger deal space, direct lending will increasingly compete against syndicated loans. Funds competing there often provide covenant-loose or cov-lite structures to sponsors with similar or greater levels of flexibility.”

Shedding covenants is nothing new in capital markets. The leveraged loan and high yield bond markets went on a similar ride years ago. But with direct lending, in-built early warning signals are more important as there is limited opportunity to sell on the exposure as there is next-to-no secondary market.

Some therefore want to remain disciplined on covenant protections. “All of our European loans have covenants and even in our largest investments where we compete against the capital markets, we continue to push for strong lender protections,” says Jacobson. GC

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Silas Brown
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