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Direct lending

BlueBay’s Fobel expresses concerns over covenant lite private debt funds

Since 2012, European direct-lending loan volumes have surged 120 per cent year-on-year, with an estimated 86 funds raising more than GBP50 billion.1 As Preqin noted in its Q2 2017 private debt report2, Europe had a total of USD39.1 billion of targeted capital.  

This is encouraging news but there are reasons to be cautious, with some direct lending managers concerned by the rise of covenant lite deals and a perceived willingness to engage in risky lending activities to corporate Europe. 

One of those managers is BlueBay Asset Management, one of the pioneers of direct lending who raised in excess of EUR3 billion for its senior loan fund, the third fund on their private debt platform last August. 

Since 2011, BlueBay has completed over 70 transactions across nine geographies. The BlueBay’s Senior Loan and Direct Lending funds aim to provide credit to upper mid-market European businesses to fill the funding gap left by banks, through bespoke financing solutions for leveraged buy-outs (LBOs), M&A, corporate financing, growth financing and re-financings. 

As such, the BlueBay team has a perspicacious view of the markets and is well placed to comment on the trends it sees. 

“We’re at a point in the credit cycle when the liquid markets are arguably overheated and therefore some of the bad lending practices that you see in those markets are at risk of polluting the private debt market,” comments Anthony Fobel, Head of Private Debt at BlueBay.

“We are seeing a few direct lending funds doing covenant lite deals or deals with wide covenants. Often they pro-forma the EBITDA to make their leverage multiples look lower, which means that the actual covenant only breaches at a very high level and for a debt provider, that is a very risky way of lending.”

As more new managers enter this market and try to win market share, there is a tendency to do riskier deals. This might be acceptable in benign markets but the problem is, many simply haven’t experienced managing a credit portfolio during a credit down cycle when liquidity tightens.

“Now is a time in the credit cycle when you absolutely must keep a cool head and stick to core investment disciplines and, if need be, lose deals to people who are prepared to do more risky lending,” states Fobel. 

Investors would be wise to carefully select the private debt funds they allocate to, given Fobel’s observation above. Just as hedge funds need to demonstrate active management in periods of volatility, it is crucial that private debt funds do the same. 

So much has been made of Europe’s burgeoning private debt market that it runs the risk of glossing over the reality of the situation.

That said, Fobel is quick to remark on a couple of points that often get overlooked in this market.

The first is that some EUR74 billion of capital has been raised in direct lending strategies. That is still a tiny proportion of the overall lending to European corporates. 

“We estimate that direct lending firms lend to approximately 30 per cent of mid-market private equity deals; those below EUR500 million of enterprise value. But it represents a tiny proportion of corporate transactions. There’s still huge growth potential in Europe’s private debt market, both lending to private equity companies and also within the corporate market. In the US the percentage of loans to non-private equity backed deals is much higher,” comments Fobel. 

In other words, private debt is nowhere near as dominant as some might have you believe. This is still a relativey immature market with huge growth potential.

Secondly, Europe’s private debt market is highly bifurcated. 

When one looks at all the capital raised in direct lending strategies, there are around 60 managers with an average fund size of EUR550 million. There are still only nine managers with funds above EUR2 billion of AUM, and the average size of those managers is over EUR4 billion. 

This then, is a marketplace with two extreme tails, with a small cluster of very large managers at one end and a diaspora of fledgling managers at the other end.

It is an unusual spread, remarks Fobel. “I think part of the reason for this is that the direct lending industry came into existence largely following the ’08 financial crisis. Since then, a small number of fund managers have gained critical mass very quickly. Whilst there are still a lot of new funds coming to market, it is questionable as to whether many of these will ever reach critical mass to really grow.”

This should dispel another misconception surrounding Europe’s direct lending landscape: namely the supposed level of significant competition.

There is, undoubtedly, more competition, but it depends where one looks.

At the larger end of the market, where BlueBay and a handful of other large, established managers operate, it is still relatively uncompetitive. 

“If you’re a private equity firm and you’re looking to raise EUR50 million in a loan arrangement, you can go to 60 or more direct lending managers and probably 60 different banks. However, if you’re looking to raise a EUR250 million loan, which may be too small for the liquid markets, you can only really go to a handful of managers,” argues Fobel.

The barriers to entry for a new private debt fund are significantly higher than they are for those wishing to set up a hedge fund. After all, these are essentially illiquid, private equity vehicles requiring investors to lock up capital anywhere from five to 10 years. Before they allocate, they have to be absolutely certain about the manager’s credentials, track record, operational expertise, and so on.

BlueBay, for example, offers Euro, Dollar, Sterling, Canadian Dollar and Yen hedge share classes for each of its direct lending funds, as well as levered and unlevered versions. 

“Unlike a private equity fund, we constantly have to pay out a current yield to investors while also receiving fees and interest from portfolio companies. There is a cash pay element to the fund, which makes it very complicated and requires significant infrastructure. 

“If you are a small fund, where the only way you earn management fees is by actually making investments (management fees are earned on invested capital not committed capital), how do you build a platform to grow your business? It’s a real challenge.

“That is why I think a lot of the smaller private debt fund managers in Europe will fall by the wayside or be consolidated,” says Fobel.

He explains that within the portfolio, BlueBay makes unitranche loans of anywhere from EUR75 million to EUR300 million. The reason for that range is that, to Fobel’s earlier point, below EUR75 million there are already a lot of smaller direct lending managers who can do those deals. 

“Also, above EUR300 million, that’s where the liquid high yield loan marketplace begins. That too is a highly competitive market and therefore explains our sweet spot with respect to loan size,” confirms Fobel.

In the current economic climate, mid-market private equity groups are under pressure to find deals and put committed capital to work. This is proving challenging with price multiples continuing to rise. Overpaying for businesses and over-leveraging will ultimately not be helpful, either to private equity firms or direct lending firms supporting those deals. 

Fobel says that the team only focuses on high quality businesses in industries with growth tailwinds. Another key screening consideration is evidence of proven management teams and strong business owners: be they private equity-backed sponsors or corporate owners. 

“Finally, we look for strong credit protection in any of the deals that we do.

If we can achieve all of those things, then hopefully we will have done a good job,” concludes Fobel.

1: The rise and rise of direct lending, Private Debt Investor Dec/Jan 2015.

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