Insights series / 12 July 2021
4 reasons direct lending is growing in Europe
Already the largest of the asset classes within private debt, European direct lending is set to grow even more. Here’s a list of four main factors contributing to its rise.
1. Bank retrenchment
European bank retrenchment is expected to continue for years. Lending teams are inundated with processing Covid-19 relief loans and in the short term, don’t have the manpower necessary to chase origination.
In the medium term, Covid-19 has presented to banks a greater level of risk and uncertainty than they are willing to take. Predictably, the circumstances mean banks are focusing on their existing portfolios rather than growing them.
2. Oversaturation in the US market pushes managers to Europe
It’s not just European managers taking the opportunity to go “where banks fear to tread.”
Managers in North America too are taking the opportunity to enter Europe as their home market is oversaturated. 80% - 90% of loans to SMEs in North America are already made by asset managers, compared to Europe where direct lenders account for only 35% of the market. The only platform for growth in the US is now more demand for borrowing, rather than growth through bank retrenchment, which has now largely played out.
Oversaturation in the North American market also means that funding for direct lenders is at capacity. Putting more capital in an already saturated market would only serve to lower their returns as managers compete with lower and lower interest rates for the same borrowers. This market dynamic puts pressure on US investors and mangers to look to elsewhere – like Europe – for returns.
3. Dealflow for direct lenders is expected to increase
According to Deloitte’s direct lending deal tracker, Covid-19 deal flow stalled in H1 2020 following managers “hitting the pause button.” However, these “paused” deals are set to come back on the table through 2021 and beyond, as pressure on deployment catches up and M&A activity rises.
Data from the annual direct lending survey by Creditflux and Debtwire also confirms an expected uptick in dealflow, and not just for deals that were paused in 2020. Almost 70% of European direct lending managers responded that they believe fund deployment will build on good H2 2020 figures. Managers also expected growth to be best amongst DACH countries (29%), followed by UK/Ireland (19%) – which fell several spots post-Brexit, having been looked at as the growth leader in the space last year (by 29% of respondents at the time).
For the most established managers, dealflow more recently has included a number of jumbo unitranches, in what is another blow for bank lending, clubs of asset managers have been able to complete deals of $1bn or higher. The largest such deal globally was agreed in June 2020, when Ares Capital led a group of lenders including CDPQ, HPS, and KKR to a $1.875bn commitment to the London-based insurance firm, The Ardonagh Group Ltd.
4. Returns: strong and stable attracts market participants
In a wafer-thin world, direct lending returns are chunky, stable and therefore attractive to institutional investors around the world. In fact, these investors have already made direct lending their key focus and managers in the European space have not disappointed them. Preqin data published in January 2021 shows European direct lending funds provided more stable returns than any other private debt strategy, with funds of vintages 2011-2017 maintaining net IRRs of between 7.6% and 8.8%, returns that are relatively high compared to other fixed-income sub-asset classes. The 5% standard deviation of net IRR is also the lowest of any private debt strategy.
According to Cambridge Associates, “seasoned managers are well placed to capture the yield premia on offer and deliver attractive returns for the 2021 vintage investor.” These managers are able to leverage their skill, including in using the lock-up period to call in the covenants and pre-empt of limit capital loss. Where there have been covenant breaches, skilled workouts can secure better results than bankruptcy proceedings. These factors lend themselves well to “teams with experience in sourcing, structuring and credit workouts.”
03 June 2021 / Insights series