Private debt spotlight shifts to direct lending
No two crises are the same, and to expect financial instruments to behave in the same way in each one would be unfair and naïve. But having proved their mettle in the 2008 crisis, the Schuldschein and USPP markets seemed well placed to thrive in 2020. Not so. Instead, it was the turn of direct lending to shine. Silas Brown reports.
When the coronavirus hit Europe the direct lending community was ready — armed and primed for action.
For almost a decade, direct lending funds in Europe have been building up their firepower, ramping up fundraising and poaching senior staff from investment banks and private equity houses. There are now 244 Europe-focused private debt funds with a total of $174bn raised, according to Preqin, while there are 469 North America funds with a $208.5bn total.
In 2020, direct lenders started biting into leveraged finance markets, drawing larger credits away from other sources of finance such as high yield bonds and leveraged loans. With over $100bn of dry powder globally, direct lending funds’ pitch over the course of the pandemic has been simple: “we are prepared to go where others fear to tread”.
US direct lender HPS Investment Partners agreed a $1bn facility with Bombardier in July, so that the Canadian firm could fill a funding gap ahead of a $4.5bn sale of its train unit Bombardier Transportation to French peer Alstom, with Apollo and Ares also lending to the company.
Ares broke the record for the largest private loan with a £1.9bn-equivalent facility to the Irish insurer Ardonagh in June, with KKR, Owl Rock Capital and HPS Investment Partners joining the lending syndicate.
Many of the keenest eyes in direct lending expected this sort of headway to occur, particularly during a pandemic when certain sub-investment grade companies were struggling to find cash from governments, banks or in public markets.
“As this [direct lending] ecosystem has grown, the size of loans made by larger direct lenders has expanded, allowing us to finance larger companies while maintaining diversified, appropriately constructed portfolios,” says Peter Glaser, head of European lending at Alcentra. “Today, the upper end of middle market companies financed by direct lenders overlaps with access to broadly syndicated loan markets. As such, private credit has replaced traditional leveraged finance solutions in some cases. As direct lending continues to grow it is fair to expect that overlap to increase.”
This growth may be most acute in Europe. Some, like managing partner of Pemberton, Symon Drake-Brockman, believe the US market has matured to such an extent that growth in the next few years might be hard, as asset managers provide up to 90% of lending for the US mid-market already. Whereas in Europe, banks still dominate lending profiles of the mid-market.
Many think there will be further bank retrenchment into 2021, as they adhere to capital requirements and bad loans brought on by the pandemic. According to Drake-Brockman, this is a big opportunity and will push Europe into a wave of M&A.
“The single currency only came into Europe 20 years ago and we still have quite a fragmented market [compared to the US], particularly in the mid-market,” he says. “Take healthcare, for example: you have lots of smaller companies concentrated in parts of France or Germany whereas in the US they tend to be much larger and focused on the West Coast or East Coast.
“We’re now into that next stage of consolidation in Europe, with private equity buying technology companies and rolling them up across Germany and then on to Belgium or the Netherlands. We’re financing a number of these deals. But because private equity started in the US in the 1970s, the US market is multiple decades ahead of us in the roll-up game.”
Direct lending’s growth has not gone unnoticed. Sovereign wealth funds, which have been passive investors in certain direct lending funds for years, have begun to take more of an active interest. Many in the market think 2021 will be defined by further high profile partnerships with direct lenders and sovereign wealth funds.
In September, Abu Dhabi’s Mubadala tied up with Barings to lend to Europe’s mid-market. The joint venture, Barings Mubadala Enterprise, is looking to put $3.5bn to work in the next year, in Benelux, France, the Nordics and the UK.
This is Mubadala’s second direct lending partnership. In July it announced a $12bn programme with Apollo Global Management, aimed at larger companies in Europe and the US seeking loans of up to $1bn each.
Mubadala is not alone in entering strategic partnerships in private debt and direct lending. Credit Suisse and its biggest shareholder Qatar Investment Authority joined up to launch a private credit platform in September. The multi-billion dollar project will provide secured first and second lien loans to companies in Europe and the US at the upper end of the middle market.
Several direct lenders told GlobalCapital that Mubadala and the QIA will not be the only sovereign wealth funds to take tie-ups with established players, and many eyes in 2021 will be on Saudi Arabia’s Public Investment Fund (PIF), and whether it chooses to go down a similar path. As one portfolio manager put it: “There’s an elephant in the room. And it’s called the PIF.”
Curious time to thrive?
But some will think this is a curious time to be quite so optimistic.
European direct lending was particularly exposed to the financial crisis brought on by the pandemic. Smaller and more levered companies were hit hardest, and had limited funding options, while large companies were supported by central bank bond buying.
The head of private debt at an advisory firm says: “No matter what direct lenders say, they’ll all be exposed to risky companies on some level. There are some with exposure to leisure and retail, where lockdowns have had an immediate impact on business. But then there are other businesses that rely on furlough money, reductions of VAT and other government schemes which are coming to an end in early 2021 — with those companies, we haven’t even heard about their difficulties yet.”
But direct lenders that survive the crisis will have demonstrated to investors their ability to weather a downturn — which, according to Drake-Brockman, can only be a good thing, as it will show the resilience of the market and the funds themselves. “Some managers will be able to make their track record a virtue and others may not,” he says.
Others go native
But in other private debt markets, few will find much virtue in 2020 and many will hope to strike it from their minds for the year ahead.
No one in Schuldscheine or the European wing of US private placements expected such a substantial drop in dealflow. In fact, when the coronavirus struck Europe, private debt markets were braced for a rash of activity. During the last crisis in 2008, the US private placement market and the Schuldscheine were both more resilient than public bond markets, but times have changed since then. Central banks have rolled out aggressive bond purchasing programmes, which made public markets piping hot and ready for action. Banks were much better capitalised and able to provide companies with emergency financing, while governments were able to offer support schemes.
“The Schuldschein market clearly was impacted by Covid-19 as was true for other markets,” says Matthias Hoffmann, senior originator at LBBW in Stuttgart. “There was a substantial decline of international issuers. Moreover, the monetary intervention by the ECB in the form of PEPP and CSPP significantly affected the euro bond market while not being transferable to the Schuldschein market.”
Over the course of 2020, the Schuldschein market shed around €6bn-€7bn of its volume from the €26bn-€27bn level it pumped out in the full year of 2019. Much of this drop can be accounted for by a lack of international borrowers tapping the market. There were still some large deals, like a €2bn SSD from Robert Bosch in June, but the lion’s share of the dealflow, some four-fifths, was German or from the German-speaking region.
While international borrowers began to return in the second half of the year, such as Luxembourg pharmaceutical company Eurofins which came to market in September with a deal that eventually closed at €350m, the majority of issuers remained decidedly German for the rest of the year. This was true for the bigger deals too, with Asklepios Kliniken and Sartorius bringing €730m and €750m deals in September and October.
However, there is optimism for the Schuldschein product. “Although there is a lot of conditionality, investors and borrowers especially returned in the last few months of 2020,” says Hoffmann. “Therefore, we are hopeful that the strength of the Schuldschein market will manifest itself. Investors consider the Schuldschein as attractive due to the high quality of borrowers paired with the need to invest funds in this negative interest rate environment; borrowers highly value the flexibility of the product — namely the ability to offer multiple tenors at sub-benchmark tenor levels at attractive margins.”
It was a similar story in private placements. In 2019, UK issuers sold around £13.5bn, according to market sources, whereas in 2020 issuance volumes did not even touch £10bn.
“Volumes, at least straight after the pandemic, dipped, as European issuers focused on short term liquidity via bank facilities,” says Stephen Valvona, private placements director at Lloyds, who says that it is possible that the short term funding may be refinanced with long dated debt in 2021. “The drop in volume was on the supply side — in fact, investors’ appetite still remains very strong.”
Proof of investor appetite was evidenced with the re-introduction of riskier sectors to the market, like Brussels Airport which entered in November, points out a senior US PP investor, who adds: “Our main hope for 2021 is that companies decide to term out their emergency loans into a longer maturity profile — if so, we could be in for a flurry.” GC