European direct lending up 9% but turbocharged growth wanes

There was a 9% hike in alternative debt deals in 2018 compared with 2017, with a total of 416 transactions completed, according to Deloitte's latest quarterly report Alternative Lender Deal Tracker. The rate of growth has slowed compared with the turbocharged growth of the previous year, which saw a 32% increase in alternative debt deals.

"While growth in direct lending deals is still present, the rate of growth has slowed due to economic and political uncertainty, which, in particular, depressed Q4 deal numbers,” says Floris Hovingh, partner and head of alternative capital solutions at Deloitte.

In the 12 months to December 2018, the UK remained the most active market with 38% of all deals originating in the region, followed by 25% in France and 11% in Germany. Of the 67 participants, 15 lenders completed 10 or more deals, with slightly less than 50% completing five or more.

In the UK, 28% of deals were in the business, infrastructure and professional services sector, with 22% in technology, media and telecommunications, 14% in financial services, 12% in healthcare and 8% in leisure.

The key driver behind alternative loans is still M&A activity, with a total of 68% of deals in Europe used to fund a buyout, according to Deloitte's Deal Tracker. Around a fifth of deals were sponsorless transactions; and unitranche was the most recurrent structure to the tune of 62% of deals in the UK and 52% in Europe, while subordinated structures made up only 16% of all deals across the board.

Bigger picture
Preliminary data for the start of 2019 shows that despite negative sentiment around slowing economic growth and interest rates on hold in both Europe and the US, capital markets are unaffected. There was a notable burst of loan issuance in February, with a total of €8.7bn transacted in the first three weeks of the month to 22 February, topping the issuance recorded in the whole months of December 2018 and January 2019.

Overall, the appetite for leveraged loans continues unassuaged. The number of outstanding leveraged loans tracked by S&P in the US and Europe is now at $1.2tn, double that of the previous peak of €570bn before the financial crisis in 2007. A third of the deals boast a 6x cash flow multiple and four fifths are covenant lite, both trends having noticeably trickled down into the direct lending market.

The Deloitte Deal Tracker cites a recent study by Proskauer, which found that 62% of private credit loans in the market boasted a single leverage covenant only, with typically around 35-40% headroom in 2018. The study also noted the increased prevalence of EBITDA cures in Europe, which doubled in the same period.

Déjà vu
Comparisons between the current climate and similarly lofty levels of debt pre-financial crisis have not been lost on Deloitte's Tracker. The point made in the report is that even if borrower default rates were mirrored – annualised default rate for leveraged loans between 2007-2012 was 3.5% – recovery rates will likely be much lower than the 70% average last time round since creditor rights will be severely impaired by the lack of covenants.

"With unprecedented levels of covenant headroom currently, if any at all, lenders should be more concerned this time around that triggers are eroded to the point that intervention might be too late,” says Deloitte's Hovingh.

Another difference to pre-crisis times is that the mid-market and its abundance of direct lending funds are providing much of the liquidity. Borrowers that may have gone down the traditional syndicated loan route are noticeably opting for the direct lending funds given that pricing has been compressed and managers have raised larger funds, infringing on both the high-yield and syndicated loan market.

Fundraising
Meanwhile, the vigour in fundraising for the asset class shows little sign of diminishing. In July 2018, Ares raised €6.5bn for its fourth European direct lending fund, exceeding its initial target of €4.5bn by 45%. Once leverage is included, there will be €10bn to deploy. On the back of this, the lender completed the largest recorded debt fund deal when it financed Software business Dairy Group in January 2019 with a £1bn debt package. Bluebay is in the market with a similarly sized €6bn target, while ICG is touted to be on the trail for a landmark fund.

A key takeaway from the report is that private debt continues from strength to strength despite the year-on-year growth cooling slightly, and the asset class is expected to hit $1.4tn by 2023. It would then pass real estate in becoming the third largest alternative asset class after hedge funds and private equity.

These trends were also covered in the first edition of Direct Lending Perspectives, produced by Unquote sister publications Creditflux and Debtwire. Subscribers can access the full report here

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