This article first appeared in Private Debt Investor on 1 November 2018.

Q: Europe’s private debt market has grown considerably in recent years, but aren’t investors becoming wary about illiquid investments, at this late stage of the credit cycle?

Wariness about illiquidity is a topic of conversation at this stage in the cycle, with a flattening of the yield curve and signs of more defaults in leveraged loans, but it is very difficult to predict when rates are going to rise and the impact that may have.

On the other hand, a turn in the cycle brings its own opportunities. We are starting to see the emergence of a different type of investor, one familiar with private equity, who is willing to look at distressed or impaired loans. Not to mention, some of the big private equity firms are buying parcels of non-performing loans from banks. In other words, we are starting to see a blurring of the line between private equity and private debt.

Q: But are investors still interested in less risky credits?

Of course. The largest fund managers are still successful because they have very strong risk management processes, can source for high quality credits and can put firm credit agreements in place. This vetting system suits pension funds, insurance companies and endowments that make up 80 or 90 percent of our fund clients’ investor base. They want assets that produce a yield to match their long-term liabilities.

However, I think there is a tendency for investors in alternatives to allocate an element of the illiquid part of their portfolios to slightly higher return strategies, which might well include distressed. As the cycle turns, I suspect this is going to create more opportunities for less risk averse investors.

Q: The private debt market in Europe is much more crowded than it was. How are fund managers differentiating themselves in this environment?

Differentiation can come through track record, for one. If, let’s say, Fund I has produced a stable and steady risk-adjusted return, investors will come back for Funds II and III, and new investors will come in too. What investors do not like is volatility, so managers must demonstrate strong risk and credit management within a risk-adjusted framework.

We should remember also that even though the private debt market is more crowded, banks are increasingly less active in corporate lending due to regulatory changes. There is a large mid-market corporate sector, which would historically have been serviced by the banking sector but now increasingly utilises nonbank lending facilities. Managers are differentiating on cost, speed and flexibility to provide capital.

Q: Are fund managers keen on entering new markets?

Risk management is important, but managers still need to source deals, so they are having to look further afield. That might be different sectors, such as manufacturing, healthcare & life sciences or technology, media and telecommunications. We are also seeing an increased number of funds focused solely on real estate and infrastructure.

Real estate debt is a way of reducing risk at this stage of the cycle by staying in the sector but choosing debt over equity. Infrastructure allows investors to lock in yields to meet long-term liabilities over the next ten or fifteen years. There are a lot of opportunities in infrastructure because there is a gap between the infrastructure needed and the current level of actual investment.

We are also seeing managers look at new territories. Moving into new countries also provides diversification, and we think that the number of genuinely pan-European funds is probably growing, partly driven by the amount of dry powder at their disposal.

Q: What new countries are managers looking at?

Historically, many managers focused on senior debt in the large core markets of the UK, France and Germany. This is still where the bulk of interest is — over 70 percent of European deal activity occurs here — but as these markets become more crowded fund managers are looking at the Nordic countries, Spain and Eastern Europe.

Q: Some of these countries are wellbanked, so is competition tough?

The Nordic countries are well-banked, but there are a lot of well-run companies that are not typically courted by funds.

The same can be said for many companies in Eastern Europe, and the banking sector in many of these countries is not so deep. In Spain, the banks are heavily constrained, and there is an opportunity for the non-bank lender to move into the space created by these restrictions to meet the demand from the high-growth companies operating in a rapidly growing economy.

Speaking more generally, the modern CFO is very aware of the corporate financing options available and knows that nonbank lenders can offer structuring flexibility and speed, which drives them toward private debt funds.

Q: Are managers looking even further afield?

I think we will increasingly see Asia as a centre for private debt fund activity. We have a number of clients with offices there, which are used for either deal sourcing or asset raising. There are so many more companies in China and India than in Europe, which multiplies the lending opportunities.

Q: Are fund managers looking at nonsponsored deals?

The majority of deals are still sponsored deals linked to M&A, but non-sponsored deals have grown to the point where they account for a significant minority. Banks will continue to look for larger deals, but there are very good lower-mid market companies and they will look to non-bank lenders for capital, rather than for LBOs or bolt-on acquisitions. With the large number of funds in market, managers are seeking new opportunities and are keen to fill the void left by the banks.

Q: Looking as a whole, is it easier or harder for debt fund managers these days?

Some countries, such as Ireland, Germany and Italy, have historically had regulations that have not made it easy for direct lenders, but their governments want to encourage the growth of direct lending because they understand that it is a useful supply of capital. There is strong investor demand for illiquid credit assets and a large number of potential borrowers, so the market dynamics suggest that the industry will continue to evolve and mature.

However, it is becoming harder to differentiate as a manager given the number of funds in market chasing a limited supply of opportunities. The very largest megafunds may have between €4 billion and €6 billion and they can underwrite up to €500m. At the other end of the spectrum are platform lenders committing much smaller amounts, but both have a niche and a focus.

Q: Are they having to compete on covenants?

There was some concern that some of the covenants were getting looser and that the relationship between the borrower and the lender was tilting in favour of the borrower, with fewer and weaker operating and performance covenants, flexible repayment schedules, and so on. This was driven by the strong supply of capital into the sector. However, there has perhaps been some pushback from lenders, who are being much more cautious now. There has been a change in sentiment because the economy is at a different stage of the cycle, so lenders are remembering that the priority is not just to get another credit in your portfolio – it is much more about the right credit with the right terms.

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