Where Europe’s Real Direct Lending Opportunity Lies

By Randy Schwimmer

Against the backdrop of uncertain credit markets and directionally differing economies, an interesting cross-Atlantic investment dynamic is underway.

In the US, a dearth of systemic liquidity has eroded prices in the secondary loan market. In turn, that’s made it difficult for story credits to find decent primary issue clearing levels. Of course, that represents buying opportunities for yield players like hedge funds and special sits investors.

Europe’s loan market, by contrast, remains less driven by institutional investors, and more bank-centric. With no retail loan funds to speak of, there’s no need for daily liquidity, no wild swings of cash in and out of accounts, no relative value players pushing prices around. This results in a much more stable market.

Less trading also means less liquidity than in the US. And while that results in less volatility, it also creates inefficient pricing. Smaller loans tend to carry lower spreads than larger ones. Given Europe’s less-than-zero rate environment – three-month Euribor is negative 21 bps! – 475 basis points in spread plus a 1% floor for a single?B credit looks pretty good.

The real long-term play that has gained media attention in the past few years is the direct lending space in Europe. That market is where the US was in terms of development a decade ago. Many thought European banks would be on the way out of the leveraged loan picture, as is the case in the US. Big funds were raised over that prediction. But it hasn’t worked out that way.

To some extent banks in Europe have continued to benefit from regional relationships built up over decades. The good news for non-banks is that middle market borrowers – with facility sizes less than €250 million – tend to fall below the radar of most corporate lending teams. For those country banks that support smaller companies, their focus tends to be on working capital financing with ABL facilities or lines of credit.

In some ways, Europe has been ripe for middle market lenders for a while. As one top attorney familiar with its history told us, the fabric of the European landscape is mostly small and medium?sized companies. There just isn’t a ton of large companies there compared with the US.

But private credit funds have distinct hurdles as well. For one thing, the patchwork nature of multiple jurisdictions makes origination in Europe a real challenge.

Where there’s an opening is offering up?and?down?the?capital?stack solutions. Direct lenders have gone to sponsors and offered unitranche financings at six times leverage. But this is not the true middle market. It is the market for less bankable companies with different players, and very different credit fundamentals.

It’s also an expensive proposition to market effectively. You need to knock on all the doors in Europe,” one source says. It’s really Middle Market Lending 101. While the majority of sponsors are in the UK, you still need to have experienced executives in every major city who have a strong Rolodex of PE relationships.

What’s clear is that managers of size – Hayfin, ICG, Apollo, BlackRock, and Ares, to name a few – are retargeting their investment strategies to address the one-stop opportunities. As one fund manager notes, scale is essential. “Direct lending is hard to just start up,” he says. “The key is you have to get the ingredients and make it. You can’t just buy it.”

Randy Schwimmer is senior managing director and head of origination and capital markets at Churchill Asset Management, a credit asset management firm affiliated with TIAA-CREF Asset Management. He is also founder and publisher of The Lead Left (theleadleft.com), a weekly newsletter about trends and deals in the capital markets.

This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.

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