Europe’s Private Debt Boom

Private debt funds are quickly expanding in Europe in a business formerly dominated by commercial banks: loans to small and medium-size enterprises (SMEs). Tight capital regulations that emerged after the financial crisis, such as Basel III, are limiting traditional bank loans at a time when midsize European firms have urgent refinancing needs. Rating agency Standard & Poor’s estimates that these companies will need up to €3.5 trillion ($3.8 trillion) in funding by 2018. The gap between growing demand for loans and the shrinking supply from banks is likely to be filled by private funds, which are already reporting strong growth.

In the US, private lending started to develop about 25 years ago, after the savings and loan crisis, and the field has grown steadily. Capital raised by private debt funds surpassed $76 billion in the first 11 months of 2015, with more than $31 billion in direct lending. Yet Ryan Flanders, head of private debt products at research firm Preqin, notes that while US capital markets remain the more diversified, Europe’s are growing. “Closing the most funds and raising the greatest amount of capital, direct lending is driving a profitable private debt industry,” he says. And while the US is by far the larger market, industry insiders say Europe represents the best opportunity in private lending.

GreenOak, a global investment firm with some $5.6 billion in assets under management, makes loans to property developers and manages real estate assets for institutional investors. It’s currently finding higher yields and more development opportunities in Europe than in the US, according to Julie Wong, who is responsible for GreenOak’s global fundraising and investor relations.

Many private debt managers say SMEs are the most dynamic component of the European market. “We think there is a great opportunity in Europe right now,” says Tom Newberry, a partner and head of private debt at New York–based CVC Credit Partners, which has assets under management of $13.6 billion and focuses on performing credit, credit opportunities and special situations, and private credit. Newberry sees an opening for institutional investors as the banks pull back. “This is not so different from what has happened in the US over the past 15 years,” he adds. “Today, more than 80% of credit for leveraged mid-market borrowers in the US is provided by funds, not banks. We think that the same shift is likely to occur in Europe.” His firm defines mid-market companies as those with Ebitda of €10 million to €75 million.

Compared with the US, “there is a better opportunity in Europe, and yields are better.”

Thomas Kyriakoudis, Permira Debt Managers

Neale Broadhead, who leads CVC’s private debt team in Europe and previously ran the mid-market debt business at Lloyd’s, says commercial banks are less willing to deploy capital to small and midsize borrowers than they were in the past. “They have not gone away, but they are not nearly as aggressive as they used to be,” he says. “Now they want to deploy intellectual capital and not financial capital. This creates more and more room for firms like CVC, which are eager to provide long-term, flexible financing.”

London-based Permira Debt Managers, with assets of about €2 billion, considers Europe so attractive that it operates exclusively on its own side of the Atlantic. “There is a better opportunity in Europe, and yields are better,” says chief investment officer Thomas Kyriakoudis. Regulation, he says, is forcing traditional banks to be increasingly conservative in their lending.

PIGGYBACKING

What often happens in Europe, according to Robert Wardrop, executive director of the Cambridge Centre for Alternative Finance, is that nonbank loans piggyback on traditional commercial lending, in the form of subparticipation deals. In these arrangements, loans are split in two: a higher-rated tranche with a lower coupon and a lower-rated tranche with a higher coupon. “In this way everybody’s happy,” says Wardrop. “The bank has a piece of higher-quality debt, while the debt fund, which need not respect the same regulatory capital constraints as the bank, has a better return. That is going on in Europe in a big way, and the customers sometimes do not even know that half the loan is held by a private debt fund.” Wardrop adds that Europe’s major private equity firms have all “essentially repositioned themselves as private capital businesses, including private debt and private equity. Most of them have subparticipation deals.”

Because private debt funds don’t compete for the fee-based business that banks covet, they make more desirable lending partners than another bank might. “Banks cooperate with private debt funds in several ways,” says CVC’s Newberry. “First, in cases where most or all of the long-term debt is provided by an institutional lender, a bank or banks will generally be there to provide the working capital facilities and ancillary services such as cash management, trust services, FX needs and the like.” 

A different arrangement is where banks partner with institutional lenders to provide a full financing package that is bigger than the bank can offer on its own. Finally, says Newberry, there have been cases where banks and funds team up to provide a unitranche term loan, structured so that the bank has the right to be paid first in a credit event, with the fund taking a “second out” position. However, he says, “this structure has not seen widespread adoption in Europe.”

But with so much unmet demand from the middle market, all these configurations could become much more common. For funds in search of yield and European SMEs hungry for loans, the private debt solution is a win-win.