The Changing Face of the European Debt Market
Private equity sponsors and mid-market private companies are increasingly turning to non-bank lenders to finance acquisitions, growth and recapitalization. This article examines some of the drivers of this trend and a few of the further changes we might expect as this market develops.
The large banks have faced many headwinds since the global financial crash of 2007-2008. Beset by tougher regulations, higher capital requirements, higher compliance costs, LIBOR and mis-selling scandals and negative public sentiment, it is perhaps not surprising that the risk culture has changed in many of these institutions. Banks that aggressively chased transaction mandates pre-2007 now adopt a more cautious approach, and many have pulled back from activities like leveraged finance. Arguably, there has also been some de-skilling at the banks as many people have left due to downsizing, and a lot of those people moved into the advisory or credit fund sector.
The space vacated by the banks has been filled by a new breed of alternative lenders (credit funds or direct lenders) who have raised money specifically for mid-market leveraged finance transactions. Most of this money has been raised from pension funds, insurance companies, sovereign wealth funds, endowments and family offices. It is effectively a new asset class or a new sub-set of the fixed income market. In a low interest rate environment where yields on government and investment grade corporate bonds are tiny or even negative, senior secured leveraged finance debt begins to look like an interesting place to invest money.
Who are these credit funds or direct lenders? They are asset managers, usually part of bigger groups including private equity sponsors; many are U.S. in origin but there are an increasing number of European firms entering this space. Names would include Alcentra, Ares, Bain Capital Credit, Bluebay, GSO, HayFin, Permira Debt Managers and many more. There are now over 70 active direct lenders in Europe and new ones cropping up every month. Anecdotally, more than half of mid-market private equity transactions are now being financed by direct lenders rather than banks. The trend is continuing as the European market becomes more like the U.S. market where non-bank lending makes up approximately 80% of the leveraged finance market.
Another term readers may have heard is “unitranche,” the principal product offering of the credit fund. In some cases it is nothing more than senior secured debt. The term unitranche originated as meaning a blend of senior and mezzanine funds in one simple tranche avoiding some of the complexities of a multi-tranche structure e.g. negotiating the intercreditor terms.
So why has this happened? Why are more borrowers turning to credit funds rather than traditional bank sources of financing? There are a number of factors at play. As we have already noted, it was partly in response to the non-availability of bank financing immediately post-credit crunch and the need to find alternative sources. But in truth, many banks have returned to the leveraged finance market and typically offer slightly cheaper funding than the alternative lenders, so the question remains – why have many borrowers turned to the unitranche providers?
The credit funds can move very quickly; they are unbureaucratic with short lines of communication and they tend to be experienced people with a deep understanding of credit risk.
Unlike the banks with a hierarchical credit committee structure, the individuals at the credit funds typically have a clear idea of what they can deliver, so there are no surprises. Many sponsors have become fatigued by banks promising one thing but then coming back with less favourable terms after going to a credit committee.
The funds can be more aggressive on quantum of debt. Inherent in the unitranche concept is the idea that the debt incorporates an element of stretch or junior debt, i.e. greater than normal senior leverage. In practice, this is not always the case but it can be a competitive advantage of the funds.
The direct lenders normally prefer a non-amortising structure whereas banks sometimes need regular repayments. A bullet structure can be attractive to borrowers who want to re-invest cashflows in capex or acquisitions to grow the business. Moreover, the credit funds can be flexible and innovative around covenants and other terms and conditions. They do not adopt a box-ticking approach which has become evident at some banks. And finally they can be flexible around information – they will do the work themselves rather than needing pre-cooked due diligence reports from a Big Four professional services firm or brand name strategy consultancy.
One Stop Shop
Banks will typically hold £20-25 million on their own balance sheets in mid-market leveraged finance transactions. Consequently, for larger deals, either a club deal approach or an underwritten transaction is needed. Club deals can be cumbersome to arrange and terms will reflect the lowest common denominator. Underwritten deals, especially in more skittish markets, require wider ‘flex’ terms where fees, margins and even structural deal features can be amended in favour of the lenders if the deal does not sell well in syndication. By contrast, the funds can hold large amounts, in some cases several hundred million pounds or Euros, removing the need for club or syndication and thus giving a sponsor confidence of speed and certainty which can be critical, e.g. in auction situations.
In the early days of the development of the credit fund sector, an often heard question was, “yes, but can you trust them? If my business has a wobble, won’t they take the keys in a heartbeat?” This is a viewpoint that is rarely heard these days. The sector is more established and borrowers understand that funds want to deploy capital, make their returns and get their money back. Like all lenders, the credit funds will ultimately have recourse to their legal rights in case of need but they will be very concerned to work with borrowers collaboratively to head off difficulties where possible. In reality, there is more of a partnership approach and funds have additional finance readily available to fund growth and acquisitions.
But let’s say a word for the beleaguered banks. Many banks have now recovered from the downturn and are actively lending again. The big advantage of the banks is price. The cost of bank debt is typically lower than the credit funds although the premium has probably narrowed to around 200 basis points all-in. For borrowers it is a case of trading off price against some of the non-price factors mentioned above – speed, transparency, certainty, etc. And on many deals, banks and credit funds are collaborating. It can make sense for banks to do the revolving credit usually needed in a transaction and the first one or turns of leverage in the capital stack, with the funds supplying the balance of the financing need. In this way, banks and funds are positioning themselves where they are most comfortable on the risk/reward curve.
So what future trends can we expect to see in this space? The first thing I would say is that the credit funds are here to stay. This is not a temporary phenomenon caused by the ‘crash’ where we will return to the bank-dominated financial sector we had in Europe before 2007. In fact, I believe the fund market will continue to develop as it has done in North America, and there are new entrants continually joining the party. Secondly, we will see the credit funds doing bigger deals. Already some of the bigger funds can do transactions of £300m+ and the smaller funds can club together to do larger transactions. In this way, the funds will take market share from the lower end of the high-yield bond market (which regularly opens and closes and is a volatile market) and the ‘large-cap’ syndicated loan market.
Another trend might be increasing cooperation between ABL (receivables) lenders and unitranche providers. A combined ABL structure with a unitranche term loan behind it can be a flexible and cost-effective structure in the right circumstances and although the intercreditor terms remain a challenging discussion, progress is being made in this area.
Finally, how can a financial sponsor or borrower navigate this new debt environment? There are a myriad of funds to choose from so how do you choose between a fund or bank deal? This is where a professional, experienced debt advisor can add significant value and explains why more and more transactions involve debt advisors. A good debt advisor has significant contacts with the banks and credit funds and can run a competitive process to obtain the best market terms available for the sponsor or borrower. The debt advisor is aware of current market terms and currently there is a lot of competition between the funds to deploy capital, so a good advisor can create some competitive tension to drive a better deal for their client.