Mid-market debt has historically been provided by clearing banks, but as they have retrenched more into service providers for customers – and focussed on safer assets in the wake of the financial crash – the UK has seen the emergence of a broad range of specialist debt providers, making it by far the most competitive market for debt funds in Europe.
Despite Brexit risk, the UK remains the stepping stone into the wider European market for US debt funds and US liquidity. Reasons include the strength of the UK’s financial sector, alongside its well-established legal environment, common language and similar culture. However, we may see this change depending on the terms of Brexit negotiated.
The number of debt funds has grown considerably in the last few years with the UK now home to well over a third of Europe’s 300 plus private debt firms. The funds now open are operating across the market and creating a huge array of options for borrowers, with high liquidity in the industry.
Importantly, owner managers of private businesses are becoming more comfortable with the debt fund model, pointing the way for further growth in the years ahead. Likewise, the reputation of asset-based lenders has considerably improved and an increasing volume of this finance type is being provided to borrowers across the full size spectrum.
France is now home to a high number of domestic and international debt funds active in the €30m to €80m ticket range, providing unitranches, senior stretched or private placements (Euro PP and Schuldschein) – a medium or long-term transaction between an issuer and a small number of institutional investors.
Direct lending funds and banks can work well together when leverage remains low at a senior level. Funds can then add duration or increased leverage into the deal through a larger bullet tranche and/ or a subordinated tranche. However, when senior leverage is high and banks are being replaced by debt funds or a high yield structure, securing a super senior Revolving Credit Facility with a French bank is somewhat complex.
Looking ahead, the direct lending market is expected to expand but the rate of growth will very much depend on bank liquidity and company appetite for investments.
The market is very much open to new lenders, although some struggle to secure their target deal volume with a limited number of deals and high competition. In the future, we predict direct lending funds will increasingly look for differentiating factors to gain market share.
The direct lending space will continue to grow on other underlying assets such as real estate and infrastructure.
Although the market is still dominated by traditional banks, both national and international debt funds are beginning to establish themselves with around 50 providers now operating in the country.
Private debt funds are seen as strong competitors by banks, although some funds such as Ardian are willing to collaborate with banks. In these transactions banks typically take a senior tranche of 10%, and debt funds a subordinated tranche of 90% of the transaction debt value.
The market for debt funds is growing and now constitutes around 20-25% of the mid-market. However, we have noticed that traditional banks are willing to defend their positions and are still the primary lender when it comes to corporate financings. Specialist lenders as well as traditional banks also operate in the asset-based lending segment, which mostly relates to capital intensive businesses.
Overall, German banking remains highly competitive with more than 1,000 banks operating in the market, reflecting the local nature of many of these organisations. As such, banks will continue to show a high risk appetite due to the ongoing competition.
Another financing instrument which could increasingly replace traditional bank loans, due to its longer maturity, is the Schuldschein (SSD). This is a debt instrument that combines the properties of conventional bank loans and bonds, but is far less onerous in terms of administrative requirements than a conventional bond.
The reluctance of Irish banks to deploy capital in the wake of the financial crisis, and the resulting funding gap for businesses, created a significant opportunity for alternative lenders to enter the market.
In particular, the Irish government has provided significant funding to support alternative lenders through the €8bn Ireland Strategic Investment Fund (ISIF). The fund has allocated capital to a number of alternative debt funds including BlueBay Asset Management, BMS Finance, WLR Cardinal Mezzanine Fund, Activate Capital and Quadrant. Other direct lenders active in the market include Swedish investment house Proventus, Pricoa Capital and Broadhaven.
Debt funds are typically more flexible than traditional senior lenders. Their funding structures have lighter financial covenants and minimal amortisation, and as competition has intensified we have noticed a convergence of historically high single-digit interest rates from debt funds near to the senior lending margins traditionally offered by corporate banks.
However, the alternative lending sector is still in its infancy when compared to a market such as the UK. That said, we believe there is capacity for more lenders to enter the market given the current demand for flexible debt financing.
The debt market is still heavily dependent on banks with around 80% of the market volume financed by commercial banks, with the remainder supplied by alternative lenders.
In recent years there has been further consolidation of the banking market, which may create more opportunities for alternative lenders to thrive, although Spanish commercial banking is currently showing significant aggressiveness in pricing.
There are numerous differences between the two financing methods, although there is one parameter in which they concur – the leverage ratio. Both traditional banks and alternative lenders are accepting a maximum leverage ratio of between 4x and 5x.
Between 2012 and 2014, refinancing/ restructuring operations proliferated in Spain, but recently we have seen a significant fall in activity. However, many of the refinanced deals will expire over the next two to three years, thereby creating a great opportunity for alternative lenders to gain more business.
This opportunity for debt funds is heightened because of the higher capital requirements being placed on commercial banks in the wake of the Basel III regulations.
The first quarter of 2017 was notable for the conclusion of the sale of Novo Banco – the transition bank that assembled the least problematic assets of Banco Espírito Santo – to the US fund Lone Star, which now controls 75% of its capital. The deal completes the stabilisation of the financial system after the 2011 banking crisis, as other major banks announced their own recapitalisation processes in 2016.
During the crisis, banks’ profitability declined significantly, but more recently there has been some recovery. As a result of new regulatory requirements and the efforts of shareholders, banks are now much better capitalised and are in a position that will allow them to support the continued recovery of the economy.
At the moment the debt market has not opened materially to alternative lenders, and there are fewer debt funding options available to mid-market businesses than in other European countries.
The alternative lending market remains in its infancy with just one domestic debt fund, Capital Four, active in the country and only participating in sponsored transactions on top of bank finance. There is, however, some limited involvement from other Scandinavian and UK-based funds.
We expect the alternative finance market to grow in the coming years, with more direct lenders and funds looking at the market opportunity. That said, some regulatory conditions do currently exist, which make it diffi cult for a foreign lender to compete with domestic lenders.
Banks ultimately still dominate the wider M&A market, with the terms they offer seen as competitive on both structure and pricing. There are few banks operating in the market and fl exibility on structure is therefore somewhat limited, with a lack of alternative lenders.
In terms of the asset-based lending market, this remains dominated by banks along with some leasing companies and it has not opened to overseas specialists such as those operating in the UK. However, businesses in Denmark with a large balance sheet typically use leasing for some of their finance.