Direct lenders take up bank slack

Lower levels of bank lending are opening up opportunities for private debt, according to Joseph Mariathasan 

Towers Watson was overweight loans against high-yield bonds for some time. The reasons were clear, according to Chris Redmond, global head of credit at Willis Towers Watson. For a long period, loans were harder to access, somewhat harder to hold and somewhat harder to transact. If you were private, you could get preferential access to information, you had covenants.

“We did not think the market did a good job at pricing those attributes. Loans tended to trade close to high-yield bonds in terms of spreads but with loans you had additional protection. So for a decade we preferred the asset class.” 

But, more recently, there has been an erosion of covenant terms with covenant-light (cov-light) loans, where the protection for investors has become bond-like. About half of new loans are now cov-light, says Redmond, and access to loans has also become much easier. “We have also seen, especially in the US, loans being accessed via ETFs and mutual funds,” Redmond continues. “People are getting over the barriers to access and therefore eroding some of the extra spreads available.”

Europe, however, is not as advanced as the US in this respect. It is still harder to access, but it is also becoming a more efficient asset class. Redmond says: “We still see opportunities and still see it as a good place for pension funds to deploy capital. If you looked at the long-term Sharpe ratio of loans and bonds, you would have found loans to be superior. But our historic bias to owning loans over high-yield is beginning to decline.”

For investors, it is important to distinguish between large syndicated loans and smaller loans are typically undertaken on a bilateral basis. At the larger end, with enterprise values above €1bn, you see companies approaching the capital markets with widely syndicated debt on which they can try and drive the price lower and loosen up documentation with cov-light structures, explains Graeme Delaney-Smith, head of direct lending at Alcentra. 

“Within the US, where tradeable loans have been around for a lot longer, the general view is that 85% or 90% of debt is provided by institutional lenders, as against banks,” Delaney-Smith continues. In contrast, the European direct lending market is much more of a private market: “It is generally large borrowers who go for syndicated debt. Direct lending is a private negotiation between the borrower and the lender and we are sole lender on 70% of the transactions.” Direct lending is focused on mid-market companies with firms like Alcentra concentrating on enterprise values in the €50-750m range.

Private equity firms have raised considerable amounts of capital, which they are keen to deploy. While multiples can be high, they are still not as high as they were pre-crisis, Delaney-Smith says: “There is a more conservative view taken by private equity firms. There is weak economic growth and private equity firms are not expecting a large amount of growth. A lot of activity is consolidation of industries: buy-and-build strategies being pursued, especially in the middle market”. 

From an LP point of view, says Mark Nicholson, a partner at SL Capital Partners, they are pleased to see GPs being disciplined and walking away from deals where they see the pricing as too high: “Private equity firms are not taking on as much leverage as is being offered by the banks and debt funds.”

The direct lending market in Europe looks to be in good health today. There were issues in portfolios in 2009, says Delaney-Smith, but the economic backdrop improved in 2012, providing opportunities for companies to grow in Europe: “The European mid-market needs around €2.7-3.1trn over the next four to five years for refinancing and to fund growth. But European banks are focused on deleveraging. As a result, banks are lending cautiously whilst there is a lack of alternatives.” 

The demand for private debt is fuelled by the private equity acquisitions. Private equity dry powder remains high, providing opportunities for debt firms such as Alcentra with established close relationships with the European private equity players. Investors are hunting for yield but they also want safe secured lending: “European mid-market loans are ideal,” as Delaney-Smith puts it.

“The European mid-market needs around €2.7-3.1trn over the next four to five years for refinancing and to fund growth” 
Graeme Delaney-Smith

Direct lending is competing with the banking industry so, not surprisingly, many of the staff have a bank credit background. But Alcentra operates in a different manner, according to Delaney-Smith. “Banks tend to segment functions, so leveraged loans are separated out from the credit function, and once a loan has been made, they would have a relationship manager covering the company. We keep it all with the same team. It takes a three to four-month timeframe for due diligence. The analysts responsible then stay with that company for the next three to four years.” 

Unlike investing in liquid syndicated loans, where a CLO manager may be able to change his portfolio if a credit looks as though it is deteriorating, direct lending loans are generally illiquid. As a result, says Delaney-Smith, it is important to monitor covenants to give warnings and control of underperformance. “If a covenant is broken, we can reset it if it is just a blip in trading, or the shareholders may need to put in more capital, or the management may need to change their business model. 

“Covenants provide an early-warning system to tell us to begin a conversation.” In contrast, syndicated loans are cov-light. Delaney-Smith says: “Private equity firms would rather not have covenants, so they are free to run businesses even in the face of under-performance. However, if the business is significantly impaired the recovery of the debt may be at significantly higher risk than that expected under the original investment case. However, you do have liquidity in syndicated loans.” 

That trade-off between liquidity and covenants can only be made by firms with the resources to undertake detailed monitoring. Alcentra receives nearly 300 sets of monthly accounts, as well as quarterly reports on portfolio loans. While such information can give an oversight of what is happening, the sheer volume of work required means that the direct lending market is not likely to see a flood of new players beyond those already established anytime soon.

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