November 20, 2017 / 10:04 AM / 10 months ago

LPC-European direct lending at a crossroads

Nov 20 (Reuters) - Discipline in the European private debt market is wavering as funds compete to offer the best terms and pricing for borrowers in an environment awash with liquidity.

Few funds operating in Europe pre-date the global financial crisis and have only worked through a period of low default rates, so many are unable to demonstrate an investment track record during difficult economic times.

“All ships are expected to float in a benign credit environment,” said Anthony Fobel, managing partner of BlueBay’s private debt business, at the SuperInvestor Conference in Amsterdam last week.

“Until there is a full turn in the cycle, it is difficult for investors to determine which are the good and bad funds.”

Private debt in Europe has flourished from investors searching for yield as interest rates remain at historic lows and banks reduce their lending under increased regulatory pressure, opening up opportunities to provide debt financing to middle market companies.

But a market that once generated double-digit returns shortly after the financial crisis is seeing a sharp compression in margins.

Unitranche loans, which combine a senior and subordinated piece of debt into a single tranche, were pricing at around 800bp to 850bp a couple of years ago but have dropped to around 700bp to 725bp, according to research from debt advisory firm Marlborough Partners.

This is a reflection of the record amount of capital raised by managers from institutional investors. ICG has €5.2bn ready to deploy for its senior debt fund. In March, Alcentra reached a final close of €4.3bn, while BlueBay and Hayfin recorded fundraisings of €3bn-plus this year.

Sponsors are taking advantage of the increased competition between funds, with many noting that leverage in middle market loans is reaching 2007 levels and risk is not priced appropriately.

“Stretched senior is just a word to justify very low pricing,” said Francois Lacoste, partner at Idinvest.

Tara Moore, managing director at Guggenheim Partners, said that the market now was not the same as 2007, pointing to higher enterprise values of middle market companies than during the crash.

“A couple of years ago, banks were at two to three times and they have stepped up a gear recently to offer deals at around four to five times. To remain competitive, unitranches are going up, but there is still a huge equity cushion. You’re playing 5.5 times debt against enterprise values of 13-14 times Ebitda,” she said.

TERMS AND CONDITIONS

Funds are not just competing on the economics of a transaction to win a deal. They are marketing themselves on their ability to deliver decisions on credits to borrowers quickly, and that has had an impact on credit assessments.

“We don’t lose deals on terms, but the biggest risk is that the rigor of due diligence is being lost,” said Paul Johnson, partner at EQT Credit. “We’ve lost deals asking one or two too many questions.”

Lowering standards on call protection also means funds run the risk of their deals being refinanced later.

“Funds should be demanding call protection, as it is crucial to make good money on all the deals which don’t go wrong,” said Paul Shea, managing partner at Beechbrook Capital.

“Because when the cycle turns, all your good assets are going to get refinanced. Without protection, that loan at 6% plus one year of fees is only going to make you 1.08 times multiple. And on your bad deals, you’re going to lose money.”

Many managers have turned to fund financing in an attempt to meet investor expectations as margins on transactions continue to decrease.

Banks have been keen on offering leverage at the fund level, with financing priced at 200bp over Libor in today’s market, down from 300bp a couple of years ago.

A recent survey from the Alternative Investment Management Association found that more than half of managers use leverage.

But the use of leverage has not translated directly into a further decrease in spreads.

Permira Debt Managers offers both levered and unlevered sleeves to investors, but the exposure is to the same pool of assets.

David Hirschmann, head of private credit at PDM, said: “We use fund leverage, but it is a question of addressing the yield requirement for our investors.”

“But that doesn’t solve the issue of tighter pricing. It has to work for both sleeves, so the deal has to remain attractive from a risk perspective.”

LOOKING FORWARD

Many managers remain optimistic about the future of the asset class, noting the increasing opportunities outside the UK market, especially in large economies such as France and Germany.

“This was the first year that our European offices out-originated the UK office,” said Blair Jacobson, partner at Ares Management.

And while the majority of opportunities are still dependent on private equity activity, sponsorless deals are increasing.

Even with margin compression in the private debt market, the relative illiquidity premium increases as public assets continue to tighten. And with international political uncertainty continuing into 2018, funds are hoping that investors may move towards assets less immune to the volatility.

Patrick Stutz, chief investment officer at Bayshore Capital Advisors, said: “If investors see a bad number in their capex statement, they start making the wrong decisions. Sometimes it is better not to see that price every day and instead be locked up for a couple of years.” (Editing by Christopher Mangham)

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