Those two driving forces look set to continue, even amid concerns about a bubble, as tightening capital rules continue to trammel banks and interest rates remain at historically low levels.
Five years ago Europe comprised just 15% of the private debt market in terms of funds raised, a fraction of the US’s 80% market share, but by 2015 Europe’s share had grown to 35%, according to data provider Preqin.
Last year, non-bank lenders such as private equity firms and specialised credit shops raised a record $ 19.7 billion for direct lending funds, beating the $ 15.3 billion that was secured by their US counterparts for the first time.
European fundraising fell behind the US in the first half of 2016, leaving it lagging in the year to date, though fundraising was stronger in Europe again in the third quarter.
Max Mitchell, head of direct lending at asset manager Intermediate Capital Group, said: “Private debt is now a structurally permanent feature of the borrower landscape. Borrowers like talking to and raising money from direct lending funds, rather than historically they only really raised money from banks.”
Banks’ misfortune is private lenders’ gain
Tightening bank regulation following the financial crisis has created an opportunity for private lenders to step in and provide alternative credit, particularly in the private equity-backed arena. Capital requirements under Basel III, for example, are expected to increase the cost of borrowing and may limit banks’ ability to lend without raising additional capital.
Nick Smith-Saville, head of European credit research at Mergermarket’s Debtwire Analytics, said: “Banks are not willing to do the deals. You will see direct lenders taking more market share [as a consequence].”
The European Banking Authority is considering further regulation that would cap the rate at which banks could lend in Europe, which could create even more headroom for alternative lenders. It plans to follow in the footsteps of the US government and cap bank lending at six times earnings before interest, tax, depreciation and amortisation, with new leverage proposals due out by the end of 2016.
The cap would hinder private equity, which relies on debt availability to help finance leveraged buyouts, but could create an opportunity for diversified firms to step in and provide credit.
Nearly a fifth of sponsored syndicated leveraged loan transactions in Europe were levered at six times ebitda or more in 2015, according to Standard and Poor’s LCD unit. These deals and others between 2014 and the end of the first half of 2016 ranged from €30 million to €6.8 billion in size.
Although many of these syndicated loans are larger than those that alternative lenders would provide, they would be directly affected by such regulations, forcing borrowers to look elsewhere. If these sponsored loans were wiped from the market, alternative lenders might be able to step in and provide loans for the smaller deals.
Mitchell said: “Anything that makes the banks retreat further is a positive for the non-bank private debt market,” not referring specifically to the EBA’s proposal.
Relative returns attractive
Aside from banking regulation, another factor that has caused alternative lending to proliferate in Europe is the relative rate of return.
More than half of the institutional investors polled by Preqin in a September report, 51%, said they intended to make another commitment to private debt by midway through 2017. Two-thirds said their investments had met expectations and nearly a fifth said they had exceeded them.
Smith-Saville said: “As [there is] greater investor acceptance, [we] see more money [being] put there. Last year was the coming of age.”
However, overall fund performance is declining. Average returns on direct lending funds fell to 6.9% for 2012-13 vintages from 14.4% for 2008-2009 vintages, according to Preqin.
One reason private debt remains attractive to investors is that it is high-yielding compared to government bonds such as gilts, which reached record lows in August after the Bank of England cut its benchmark interest rate. The UK cut its interest rate to 0.25%, and some European interest rates are in negative territory.
“Our ongoing ability to raise capital is very strong,” said the head of origination at a major private debt provider. “The attractiveness of private credit to pension funds is still there.”
Can private lenders take the heat?
As investors continue to crowd into private credit, despite apparent declines in fund performance, the danger is that the market could overheat.
European direct lenders were sitting on $ 27.8 billion of dry powder as of September 2016, up from $ 4.7 billion in 2011.
Firms that diversified into private debt in recent months include asset manager Hermes, which launched a new lending operation for small to medium businesses in September; private equity firm Vision Capital, which shifted its strategy to focus on private debt in July; and private capital provider SL Capital, which launched its first private debt fund in July.
Mitchell said: “[Growth in the European market has] been driven by demands from borrowers. New entrants [are] a natural consequence of a market growth.”
However, an increase in supply could spur private lenders to either “loosen terms” or “loosen pricing”, which would further affect overall returns, according to Smith-Saville.
The managing partner of one private equity firm active in the UK midmarket said: “Private debt – I think that’s a bubble waiting to burst. Everyone is piling into it. It’s very easy to get great terms on debt for deals that you are doing but we wouldn’t look to diversify [into private debt].”