The European direct lending market hit an all-time high in 2017 with EUR 32.1 billion raised, which was followed by EUR 248bn in 2018, according to Debtwire Funds data. This year so far (up to May) EUR 16bn was raised across 11 managers, with at least another EUR 10bn expected to come, which suggests it will be another strong year for direct lending.

While it bodes well for fundraising, it also means competition is fierce and securing deals might mean accepting less than ideal terms or going the extra mile.

PE Wishlist

For private equity firms at the event, for whom the rampant competition in lending has resulted in cheaper prices and higher leverage, flexibility becomes the feature that will set lenders apart. Usually, this means they are working with debt funds that they know well, who can move quickly outside the process and be reliable if something goes wrong.

“It comes down to who you trust,” said one private equity partner.

“Relationship, flexibility, deliverability and trust are massive for me. Terms are so similar now. We don’t work with a new fund unless we know the people, and we always due diligence the fund.”

Private equity firms said lender educations are not that useful anymore, particularly on well-known names in the market. And they are also not the first place they look for potential financiers.

They highlighted that stretch senior and unitranche are complementary, with funds offering more choice.

“There’s room for both. Leverage and pricing are the main differentiators,” added the partner. He added that stretched senior offers better pricing versus leverage.

The private equity firms agreed club financing in size is difficult, with one of the panelists calling it “too painful”. They saw banks mainly as providers of ancillary facilities as well as super senior portions of first loss/second loss unitranches, but emphasized maintaining that relationship is also important.

They named add-on flexibility, covenants, EBITDA flexibility and lack of restrictions on the acquisition facility as their top priority when it comes to documentation.

LPs look to lower mid market and multi-strategy

Limited partners (LPs) are equally keen on relationships as they pour more money into the market and are keen to push for co-investment with favoured managers. However, panelists highlighted that some LPs are not set up to move at the necessary pace when presented with opportunities to co-invest. Some LPs are favouring a ‘if it fits my criteria just call my money’ type of strategy to circumvent this challenge.

The lower mid market was seen as an area of opportunity, but pricing and documentation needs to make up for the extra risk, said the panelists. This was also highlighted by Ravi Anand from ThinCats, which presented the firm’s high volume, low risk SME lending strategy, enabled by their “scalable credit” automation technology.

“War stories” of how a debt fund handled a challenging situation, such as tested covenants, can be a selling point for LPs conscious of the turbulence ahead. “How do you react? Did you figure it out to my advantage?” said one LP.

LPs are keen to park their cash with multi strategy funds/special situations who can utilise flexible mandates, away from traditional distressed lending. They also believe the sponsorless space will continue to grow, although they think pricing and docs should compensate for it.

What happens when direct lending turns distressed was at the forefront of most panels, with panelists saying covenant resets and restructurings in the mid market space are on the up. However, some panelists highlighted that with funds raising more money and portfolios getting bigger, this is bound to happen.

Distressed dynamics in the downturn

Panelists said underperformance seems to be concentrated on vulnerable industries such as retail and casual dining, or one-off problems, rather than a systemic challenge.

But they did agree the next downturn will be the true test of direct lenders who have thrived in the benign economic environment. This will be when relationships will be truly tested—those who adhere to “patient capital” will survive, said one panelist.

The dynamics between senior and super senior lenders in a distressed scenario were addressed by the panelists, with one saying that many times the bank lender does not get access to information until the last minute.

Transferability restrictions, while a headache for some, are not as important to direct lenders, said one panelist, as funds are usually reluctant to sell to distressed players.

Sunny skies in Southern Europe

A keynote address by Paul Johnson of the Institute of Fiscal Studies, showed UK household income has remained stagnant, growth forecasts are low, and a “disorderly” no-deal Brexit could result in a precipitous drop in the UK’s GDP and business-to-business trade with the continent. This impending macroeconomic climate will only make deals more challenging.

Even while clouds are on the horizon, new opportunities in new markets are being spotted by lenders sweating in the overheated Northern Europe.

Funds are increasingly looking to move beyond “beer drinking” countries and explore opportunities the “wine drinking” southern European countries. Panelists see an increase in sponsorless deals in the regions, which take more resources and time, plus a need to educate the market on the opportunities of private debt.

Panelists highlighted the need for native speakers on the ground to build relationships, but different strategies with local teams and London-based teams that travel regularly also a possibility.

“There’s an element of commitment” to having a local office, said one fund. “We have to set a standard in the market that debt funds are key and important.”

The panelists discussed the challenges in Italy to provide unitranche given the local restrictions, and how this has generally been circumvented via bonds. They further highlighted that pricing tends to offer a premium over traditional markets.

With the growth of the market and uncertain economic landscape ahead, the relationships built now will surely be tested. But the returns are tempting enough to keep those ties strong, panelists said.

Karis Hustad Mid- Market Reporter Debtwire

Karis is a reporter covering M&A and leveraged finance in the UK and Benelux mid market.