Ares Management is one of the world’s largest alternative credit managers and direct lenders. It manages more than $100 billion, of which approximately two-thirds is across a variety of credit strategies with more than half of that – around $41 billion – is direct lending. This year, Ares marks the 20th anniversary of its founding in 1997.
Having established itself in the United States as a leader in direct lending, Ares brought its direct lending expertise to Europe in 2007 as a natural complement to its US business. The firm viewed European non-bank lending as a vital and growing component of the debt capital markets, a trend that accelerated with the global financial crisis.
Ares Credit Group Managing Director Daniel Sinclair was invited to speak at the SYZ Hedge Funds Day, held in Zurich on October 31, 2017. SYZ invests in selected hedge funds, including direct lending strategies, alongside its clients. Sinclair set out Ares’ investment thesis for European Direct Lending in a presentation entitled, “The Evolution of the Direct Lending Opportunity in Europe”.
Pre-crisis, Sinclair recalls how “…the European lending market was overbanked for mid-sized companies – whether they were management-owned or sponsor-owned. Banks were doing a great job”. At that time, Sinclair was in the Financial Sponsors Group at Barclays PLC, where he originated and executed mid-market leveraged finance deals.
A decade of European direct lending
In 2007, Ares was arguably the first true direct lending platform in Europe. The firm identified the opportunity in Europe for non-bank lenders to play a pivotal part in the growth of capital markets.
Many consider the summer of 2007 as the approximate start of the credit crisis in Europe, which accelerated growth for the non-bank lenders. European banks began their quick retrenchment, leaving a funding gap for corporates and financial sponsors, who needed to finance their growth strategies. The sweet spot was – and still is – seen as mid-market companies with EBITDA between €5 million and €100 million seeking debt financing anywhere from €20 million to up to €500 million of capital.
Ares seized the opportunity to build close relationships with financial sponsors (including private equity firms) and portfolio companies. Over the past decade, Ares has put more than €10 billion into approximately 150 investments across Europe, involving nearly 90 different financial sponsors. Ares has originating offices in London, Paris, Frankfurt and Stockholm, and maintains close contact with sponsors and management teams across the region. In the second quarter 2016, Ares closed its third European direct lending fund, ACE III, with €2.5 billion of investor commitments.
Direct lending continues to become more relevant to larger borrowers as the product gains increased acceptance as more established participants have gained scale and developed a strong track record over time.
A very large opportunity remains for both the asset class and Ares’ business to grow as bank consolidation, balance sheet deleveraging, and continued bank retrenchment have created a significant funding void. “It remains incredibly difficult for a financial sponsor or management team to raise up to €250 million of debt financing. The time and complexity required to get a number of banks to advance that amount remains challenging for borrowers or sponsors, as they seek to differentiate themselves via speed of execution in a competitive market,” according to Sinclair. Though public credit markets are clearly open to larger issuers, “the volatility of liquid credit markets, particularly high yield, deters financial sponsors that require more certainty around financing deliverability and execution,” he adds.
A relationship business
Competition is growing in European direct lending, with an influx of new entrants. “In 2013, there were a handful of direct lenders and the number has grown in recent years,” says Sinclair. However, some of them are struggling to deploy capital noted Sinclair. The proliferation of market participants makes it easier for advisors and intermediaries to compare terms across multiple providers. Sinclair highlights some criteria that borrowers may want to consider. “Financial sponsors expect to work with a firm for five to seven years —over the course of an investment. This means that relationships can be as – or more – important than the rate of interest on the loan.” Ares not only competes on price, but it leverages its strong relationships and emphasises scale, credibility, flexibility and speed of execution. Ares has consistently exhibited stable returns even as some segments of direct lending experience yield compression. Sinclair notes that “an incremental interest rate of 25 or 50 basis points has a negligible effect on overall equity returns for financial sponsors. More impactful is the capability of financial sponsors to fund incremental and accretive acquisitions, through follow-on capital that can bedetermined at the time of the initial investment or subsequently. They also need to know that their financial partners will be there if there is a bump in the road. We have established credibility with sponsors over 10 years and through our completed deal track-record. We have been invested with some portfolio companies, which have seen a change of financial sponsor during our investment.” Sinclair finds that management teams may be wary of fund launches that are perceived to be opportunistic, rather than long-term franchises.
The breadth of lenders’ offerings is also important. “We can offer a range of debt capital products from senior and unitranche loans to subordinated loans. Thus we expect to be involved from day one, helping us see the transaction early and therefore be ahead of the curve in understanding the opportunity. Those with a narrower product set may only be introduced later on in the process,” he explains.
Attractive risk adjusted returns
Sinclair expects the same historical level of returns for the European direct lending strategy to be achievable going forward. To date, this strategy, which manages approximately $11 billion in AUM, has generated over 10% asset level gross returns.
In Europe, Ares runs both levered and unlevered strategies. Investors can benefit from annual running yield and as the majority of loans are floating rate, this could ratchet up if interest rates rise.
Measured in terms of spread per turn of leverage, Ares sees 1.5-2.0 times additional spread per turn of leverage in the illiquid markets versus the liquid markets today. The extra yield can be seen as an illiquidity and a complexity premium, but given the low level of credit losses in direct lending, it has not historically had to act as compensation for higher credit losses.
Loss rates have been extremely low on an absolute basis and lower than those experienced in the liquid markets, according to Sinclair, albeit, the European direct lending asset class has only been of scale for 5 years. However, Sinclair noted the low loss rates are partly attributable to the deals predominantly being first lien on operating companies and associated assets. Another safeguard is the level of control Ares has over the deal structure and ongoing monitoring. Ares directly originates loans, carries out due diligence on companies alongside financial sponsors, benefits from its board seats (approximately 20% of investments have board observer seats), and receives monthly financial data from portfolio companies. Collectively, Ares’ engagement with its customers protects its investments in a down-cycle. If borrowers default, lenders may need to restructure debt in various ways such as renegotiating terms and this is something that Ares is well versed in. “We have been very successful in the few workout scenarios we have had and have a team of professionals with significant restructuring experience,” says Sinclair.
Risk mitigation also comes from covenant protection in deals, though Sinclair admits that borrowers are exercising some pressure on this: “Senior loans in the liquid market are now experiencing more covenant-lite features. We have never underwritten a covenant-lite deal, but we are seeing fewer covenants. In 2008, every deal had four covenants, but now they have closer to two per deal on average. We remain focused on obtaining those covenants that provide the most robust protection.”
Typically, Ares makes 50 investments within a portfolio, creating considerable diversification, more so than some other direct lending strategies.