Are banks in denial over direct lending?

IFR 2162 3 December to 9 December 2016
6 min read

I’VE BEEN WATCHING with interest the emergence of direct lending funds in Europe over the past couple of years and I’ve been moved to pose a question.

Are banks in denial over the impact of direct lending strategies employed by private equity firms, institutional money managers and hedge funds?

I’ve been impressed by the significant quantum of cash being put into this alternative debt strategy in Europe, but any enthusiasm I’ve shown has been met full-on with a resoundingly dismissive shrug of the shoulders by syndicated loan bankers.

Bankers roundly reject the narrative that tells of banks withdrawing from lending relationships and the gap being filled by non-bank capital. They scoff at this facile misinterpretation of the facts. The best they’re prepared to offer is that non-bank direct lenders may be complementary in specific situations where banks aren’t in a position to, or don’t want to, keep specific asset profiles on the books.

They concede funds may have more of an “in” with sponsor-owned companies; otherwise they’re chasing opportunities in areas the banks would rather not play in.

Bank lenders see the entry of direct lenders into the world of corporate lending as a direct corollary of very tight bond market technicals, where low returns have squeezed them out. Funded loans have moved onto their radar screens.

But of course a lot of the corporate loan market is in the form of unfunded commitments, so bankers say there won’t be a huge amount of opportunity in the core corporate market away from distressed, mezzanine, leveraged/LBOs or special situations - bearing in mind that short-term funded loan commitments are invariably taken out in the bond market.

On pricing, bankers say the funds would be unable to compete head-on even if they wanted to because they can’t play the ancillary or relationship card and their return hurdles are at a significant premium to bank pricing.

Hence banks say direct lenders are marginal since the kind of paper the direct lenders are looking for and their yield hurdles aren’t readily available. As long as competition among bankers to book assets with core corporate clients continues to be strong, as it does in many top European jurisdictions, bankers say the funds won’t get a look-in even in the mid-market space they nominally target.

“There’s a difference between a Double B minus-area LBO loan with five or six times leverage where you know where the leverage is coming from and lending to a smaller SME,” a speaker at IFR’s recent German SME Funding roundtable said. “The difference is, as a core bank, you have probably known the company, management and shareholders for years.”

OTHERS COUNSEL CAUTION: “The moment the funds lower their yield requirement to a level where they can compete with a difficult crossover corporate, bang will go that difficult crossover corporate for the banks,” said another roundtable speaker. “I tend to agree with that core relationship element but the moment the borrower is able to get his funding from this new guy in town, he’s more than happy to take it.”

While some of the chatter has been conciliatory, the broadly negative reaction among banks to direct lending funds comes in almost direct contrast to the sheer volume of cash being raised and put to work in European direct lending in recent years.

Alternative assets data and intelligence provider Preqin said in its November update that 2016 might not have been a banner year for Europe-focused fundraising, with US$16.8bn raised across 28 funds.

But those funds that have closed have invariably closed ahead of target. And it’s noteworthy Europe outstripped the US last year with US$33bn in aggregate commitments. Preqin is tracking 74 funds in the market seeking more than US$36bn and calculates Europe-focused direct lending fundraising increased by 437% between 2012 and 2015, compared with 144% for North America-focused funds over the same period.

That’s impressive. As is the amount of dry powder levels for Europe-focused debt funds: US$54bn, only slightly below the record US$61bn achieved at the end of 2015.

Intermediate Capital Group has raised the most capital in the past 10 years and has the largest amount of estimated dry powder, followed by Tikehau, Partners Group, EQT and Ardian. Other titans all have cash to put to work, including 3i, Alcentra, Ares, Bluebay, European Capital, GSO, Hayfin, KKR, Marshall Wace, Pemberton, Permira and many others.

The extent to which direct lending becomes a durable alternative debt class will obviously depend on the ability of the funds to garner deal flow and capture superior returns.

In aggregate, the funds have hired an army of experienced loan originators with solid know-how, so on that basis the impact of their efforts looks likely to over-shoot bankers’ low expectations.

To that complementarity point I made above, when Pemberton Asset Management closed its €1.2bn European Mid-Market Debt Fund in November, managing partner Symon Drake-Brockman said high-quality European companies were struggling to access finance to fuel growth, but traditional lenders were looking for partners to share financing and investors were seeking long-term sustainable returns in a low-yield environment.

“We believed that the solution was in combining institutional capital with relationship banking, transmitted through a strong risk-management and credit-underwriting platform … we have delivered a strong alliance of quality companies, regional lenders and institutional investors that we will continue to build on in the future,” he said.

Far be it from me to nay-say the bankers’ sniffy response and (potentially feigned?) disinterest, but that sounds like a good combo to me.

Keith Mullin