Direct lending funds – which act like banks by lending money to private companies, often those owned by private equity firms – have had a funny few years. They have had more cash than they have known what to do with.
Europe-focused direct lending funds raised a record-breaking $ 18.8 billion in total for deals in 2015, a 48% increase from the $ 12.7 billion raised in 2014, according to Preqin.
But while there has been a massive increase in European fundraising, there has not been a massive increase in European direct lending dealflow. Banks are still dominant in lending money in Europe and alternative lenders completed just 60 deals in Europe in 2015, according to the Deloitte Alternative Lender Deal Tracker. This is a significant rise compared with the 36 deals completed in 2014, but still not enough to keep direct lenders happy.
Executives now say that the Brexit vote could be a welcome boost to direct lenders’ business, pushing banks to lend less money and private debt funds to take a larger slice of the market. Firms like Swiss-based Partners Group, Intermediate Capital Group and KKR have all said in statements that they see an opportunity to invest in private debt following the Brexit vote.
Christophe Evain, chief executive of ICG, said that “the full impact of Brexit on banks’ lending activities is not yet clear” but his firm expects banks to reduce their lending in the short term. “The withdrawal of bank credit will benefit private debt funds and non-bank lenders like ICG who are not reliant on markets for financing.”
Direct lenders typically compete with European and UK banks in lending money to companies. In the wake of the Brexit vote, many executives expect UK and European banks to reduce the amount of debt they lend and also offer that debt on more expensive terms in the wake of the Brexit result.
Fenton Burgin, head of UK debt advisory at Deloitte, said banks might be less willing to lend to UK companies because of worries about a recession in the UK and currency fluctuations. He said: “In the mid-market, banks, particularly UK-centric banks, are likely to see their costs drift up slightly over the next six months and that will accelerate the development of the alternative lending space.”
He added: “Will European banks be as willing to lend in pure sterling in the coming months? Or will they say we want to lend in euro-denominated assets? My view is that you will see a range of European banks retrenching back to continental Europe [over the next six months].”
That could provide an opportunity for private debt funds to step in to fill the funding gap, agreed Paul Shea, co-founder of Beechbrook Capital.
“What we would expect to see is more opportunities from borrowers who can’t get financing elsewhere,” he said. Shea added that when companies had plenty of options for financing, they typically repaid or refinanced their debt to get a better deal relatively often. But “in the event there is less competition and a flatter lower-growth environment, people won’t be looking to repay you as early”, which would be a boon to debt funds as they would be able to put money to work for longer, he said.
The pressure on direct lenders to spend their money is exacerbated by the way that such funds pay themselves. Unlike private equity funds, where firms get paid fees based on how much money has been committed to them by investors, private debt funds only get paid fees on money that they have invested. This means there is big pressure for direct lenders to keep on spending their cash in order to keep their doors open.
Yet, while private debt funds may be able to take more market share, the market they operate in may shrink, given private equity firms are likely to scale back the number of UK deals they complete this year, according to Symon Drake-Brockman, managing partner of debt fund Pemberton. Financial sponsors are the main customers of debt funds and the UK sees the highest number of private debt deals of any jurisdiction in Europe, according to Deloitte.
“The positive side is banks being more cautious, the negative side is dealflow being more cautious,” Drake-Brockman said. “Although the opportunity will be good for non-bank lenders, you’ve also got to offset that against the much lower dealflow in the UK over the last six months, going up to the vote and for the next couple of months.”
However, Deloitte’s Burgin points out then when private equity firms find it difficult to list or sell the businesses they own, they often look to make money out of them in other ways – often by refinancing a company’s debt and using the money to pay themselves a dividend, known as a dividend recapitalisation. This could provide further opportunities for direct lenders.
“You are going to have a range of private equity owners that might have been targeting a second half of 2016 or first half of 2017 exit process who may well be saying, ‘actually we should just pause our views on sale. Should we derisk our position by doing a dividend recap?’ I think there will be a number of those scenarios that offer opportunities for direct lenders.”
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