Since the financial crisis struck almost a decade ago banks have become more risk averse and selective of the businesses they support, creating a material opportunity for alternative lenders to fill the funding gap.
The continued global low interest rate environment in the wake of the financial crisis has meant investors are searching for opportunities that deliver higher yields. This drive for increased returns has pushed significant investment to the attractive returns offered by debt funds and direct lenders.
The debt fund market has its origins in the US, where for many years the majority of lending to mid-market businesses has been from alternative lenders rather than banks.
In the wake of the financial crisis, US operators were quick to exploit the opportunity created in Europe. Following a number of cross-border deals US debt funds were soon to establish offices in London. Many firms have since expanded further across the continent such that there are now a significant number of pan-European funds as well as those which are domestically focussed.
There is huge liquidity in the market with committed funding raised by debt funds ready to deploy. Recent estimates suggest dry powder held by funds has now reached almost $200bn globally, with $55bn held by European fund managers1.
As debt funds’ presence has risen, borrowers and advisors are now more comfortable dealing with them. None more so than the private equity industry which has seen the benefits of transacting with credit specialists offering borrower-friendly structures and rapid processes.
The prevalence of debt funds and high levels of committed capital looking for a home has created stiff competition amongst lenders in the mid-market. To counter this, we are increasingly seeing debt funds looking to differentiate themselves in order to deploy capital at attractive returns.
One way is by individual funds underwriting and holding large loans, negating the requirement to club or syndicate deals, and therefore delivering quicker processes. There are now a handful of debt funds in the market which can write and hold €150m to €250m+ commitments.
Feedback gathered from Clearwater International offices indicates banks selectively remain willing to defend market positions, leading to increased leverage and improved lending terms for borrowers where they are keen to maintain or win transactions. However, exactly how this will be impacted by the ECB’s (European Central Bank) new maximum leverage cap is yet to be seen.
A number of European banks have also established strategic relationships with debt funds in an attempt to retain control of the customer relationship.
Banks must also strike a balance between defending their market share and meeting risk adjusted return hurdles against new higher capital requirements imposed since the financial crisis.
Meanwhile, the direct lending industry continues to evolve as funds look for new ways to differentiate themselves, including broadening product ranges and raising funds focussed on individual sectors.
Looking ahead, pressure on both banks and debt funds to deploy capital will increase as high levels of liquidity in the market create an extremely borrower-friendly environment. Interest margins and arrangement fees for the best credits continue to soften, although there are some signs of margins hitting a floor, driven by the returns funds have promised to their investors. This margin floor has meant lenders are looking to compete on other aspects, with improved flexibility available to borrowers.
Over the longer term we expect to see consolidation in the debt fund market as larger direct lenders look to increase their market share and remove competition. We also anticipate some funds will struggle to raise tertiary investment, due to a combination of lack of capital deployed and poor returns delivered to investors on their debut funds. With the current investor demand for yield we do not expect this imminently.
1 Preqin Quarterly Update Private Debt Q1 2017