Waiting for the direct lenders

The ongoing issue of banks' increasing reluctance to lend into the mid-market and their continued retrenchment back to domestic markets has opened up a wealth of opportunity in the lending market for institutional investors.

Of course, the notion of private debt funds is nothing new. In the last month alone, BlueBay Asset Management closed its Direct Lending Fund on €800m, wildly exceeding its €500m target, while Chenavari Credit Partners was reported to be targeting up to $1bn for its European direct lending fund after the high-profile hires of Palio Capital Partners' founders Mike Henebery, Jerry Wilson and Darren Gibson. Furthermore, Rothschild's Five Arrows Credit Solutions fund has just held a €235m first close, and in the same week HIG Capital's credit arm Bayside Capital held a final close in its HIG Bayside Loan Opportunity Fund III (Europe) on a whopping $1.1bn.

The reason why debt funds are becoming increasingly attractive to institutional investors was highlighted in a roundtable event hosted by Intermediate Capital Group (ICG) on Wednesday. Pension funds, insurance funds and sovereign wealth funds alike are all seeking high cash yields, attractive risk/return profiles, low capital loss, low duration risk and low NAV volatility. And according to ICG, these needs can be met through investing in debt funds.

Then, surely the stage is set. The banks are creating an ever-widening financing gap for buyouts, and institutional investors are seeking the returns and low risk profile offered by debt funds. But, European buyout funding is still largely dominated by traditional lenders. More than half (51%) of buyout financing came from banks in the first nine months of 2012, with the bulk of alternative lending made up by CLO funds, according to Standard & Poor's. This is significant since most CLOs are rapidly approaching the end of their investment periods, suggesting their liquidity could dry up and leave a gap. The situation in Europe is very different to the US, where 84% of buyout funding came from institutions rather than banks in the same period.

Hurdles to overcome
According to ICG, the delay in direct lending across Europe can be attributed to several factors. First, the relative infancy of this form of credit causes concerns. For the companies themselves the lack of available bank debt has forced a rise in the employment of debt advisers, who can introduce borrowers to the concept of direct lending. For institutional investors, however, the new notion of debt funds is tricky to place in existing portfolios. On one hand, credit vehicles are an alternative asset because they are more illiquid and exposed to sub-investment grade loans; on the other hand, they can be viewed as fixed-income assets due to their return profile.

Aside from difficulties around classifying debt funds within portfolios, the novelty of the funds raises questions over their possible cyclical nature and sustainability issues of the investment strategy. Furthermore, as many of the new debt funds coming to market are first timers, there is very little information in the way of track records and actual returns. This means that manager selection becomes a major task for institutional investors.

Second is the fragmented regulatory environment across Europe, with each country having individual rules around cross-border lending. The US skirts any legislative issues by classifying direct lending as a retail asset. While in Europe, despite some governments encouraging alternative lending sources, such as the UK, other markets have been historically opposed to this sort of lending.

Despite continued cries from private equity houses and SMEs for banks to increase lending, with even the UK government setting up initiatives such as the Funding for Lending Scheme, which saw the Bank of England handing out £16.5bn to traditional lenders to boost company loans, data released this week shows lending contracted by £300m in the first quarter of this year.

There is clearly an ever-growing need for alternative forms of lending, for primary and secondary buyouts, refinancings, growth capital and acquisition finance. Frustratingly though, despite the huge amounts of capital raised by direct lending funds, it still has not made its way into the asset class in a significant way.

A genuine structural change is desperately needed to boost direct lending, but while these alternative funds continue to be viewed as new and unfamiliar to legislators, out-of-date and complex legal systems throughout Europe will prevent SMEs from accessing much needed credit, as well as causing more pain for buyout firms in need of finance for new deals.

Without increasing awareness around new forms of lending to increase their familiarity in the eyes of regulators, debt funds will continue to trickle cash into deals where they can, while companies and buyout houses alike continue to fruitlessly plead with the banks.

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• Intermediate Capital Group
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