Direct lending moves into mainstream but confusion persists

According to Malcom Hassan, head of funds and asset management at RBS, speaking to unquote" in a recent video interview, there are an estimated 42 active direct lending funds in the UK, a significant jump from just 18 active in 2012. Furthermore, there are around 81 new funds currently out in market raising a combined £52bn.

This surge in alternative lenders is a clear indication of investor appetite for the strategy. Indeed, in a low interest rate environment the desperate search for yield means traditional investment strategies such as bonds or gilts are failing to deliver. The risk adjusted returns generated by direct lending funds make these investment strategies ever-more attractive by comparison. Within the European credit market, direct lending funds are achieving returns of 8-10%, against just 2-4% for investment grade bonds. Another key driver is the supply and demand imbalance. Following the financial crash, banks have retrenched to their domestic markets and reduced ticket sizes.

"It's about being long-term partners and supporting good businesses with smart capital to help them achieve their objectives," explains Max Mitchell, director of credit fund management at Intermediate Capital Group (ICG). "It is not about being the capital of last resort or chasing risk. Historically, borrowers relied heavily on their relationship banks for this form of capital but, since the financial crisis, borrowers have been looking a lot more at alternative ways to fund themselves."

Aside from impressive returns and a healthy level of demand, these funds are now accepted as mainstream lenders. According to Mitchell, in the first quarter of 2014 the number of direct lending deals was up 50% in the UK compared with the same period in 2013, and has increased by 120% for the rest of Europe.

Building barriers
Against this backdrop, it is of little surprise the market has been flooded with new fund launches trying to get a piece of the action. However, as more and more pile in, question marks over how many will actually survive are beginning to surface.

Mitchell believes direct lending is about selecting the right deals: "We manage risk through detailed credit analysis and proactively look to convert the best 5% of the deals we see into investments for our fund; we looked at 300 opportunities in 2013 and of them completed 20 deals in mid-market sub-investment grade businesses."

In order to ensure smart investment selection, ICG can spend anywhere between two weeks to a year on due diligence. "These are complex deals, which require an experienced team and lots of resources."

According to Mitchell, as the competition in the lending market heats up, winning the deal is not purely dependent on price. "Price is important but has not been the the key decider on our deals as borrowers are often looking for long-term, supportive lenders – 'partners with deep pockets' to support further growth."

Furthermore, ICG creates bespoke legal documents for each one of its transactions. As legal documentation typically favours the lender, this is an area that has the potential to discourage a borrower.

With all of these barriers to entry stacking up against new arrivals, Mitchell believes only around 10 new players will be successful in raising.

Corporate confusion
ICG is actively trying to move away from lending on private equity deals, as its first fund dedicated to this market saw 80% of investments going into acquisition finance, while its latest fund is aiming to be around 70% invested in private equity deals.

And while there is clearly a gaping hole left in the lending market by the banks, it would appear that corporate borrowers are struggling to get to grips with direct lending. With so many players in the European credit market today, a level of confusion is understandable. Says Mitchell: "Because direct lending is relatively new in Europe there is risk of misunderstanding or confusion as to what it is; therefore it is important that we – the direct lenders – communicate what we are doing better so that people understand that direct lending is not distressed lending or capital of last resort."

With around €3tn of loans coming to maturity in the next three years, direct lenders will undoubtedly be rushing in to plug the hole. But, a clever PR strategy might be needed beforehand.

American style
While direct lenders increasingly position themselves alongside corporates, is it possible that the European landscape will start to resemble that of the US, where around 80% of debt is funded by institutional investors? "I don't think Europe will ever replicate the US market in terms of the importance of non-bank lenders," says Mitchell. "European banks will remain a significant mainstay. It could reach 50:50 in the long term, with banks focusing on certain areas that they are very good at and perfectly positioned to provide."

As direct lending funds establish themselves as a key part of the European lending structure it is increasingly clear that these players need to work harder for survival. While investors are turning to these funds for their attractive returns, it will be those that have built up impressive track records that benefit from investor inflows. And, it is more important than ever that direct lenders select the right deals to work on to maintain impressive yields, and communicate clearly with all stakeholders to win over corporates.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• UK / Ireland
• France
• Nordics
• Benelux
• DACH
• CEE
• Southern Europe
• Acquisition finance
• Intermediate Capital Group
• Top story