In the second quarter of 2015 AIMA published a research paper highlighting the growing and important role of private debt funds in financing Europe’s economy. This research underlined that one of the most enduring consequences of the financial crisis is that Europe’s debt markets have moved, particularly for the funding of SME and mid-market transactions, to a model more akin to that which prevails in the US, where bank loans only account for approximately 25% of corporate debt. 2015 saw a continued shift away from banks (traditionally accounting for between 80%–90% of financing for European companies) to a variety of new debt providers such as private equity, institutional investors, insurance companies, pension funds and a variety of alternative credit providers. This shift in funding sources for European corporates is now a permanent, structural feature across a number of different asset classes including corporate, real estate and infrastructure debt.
The principal reasons for this structural shift in the European financing markets are now well documented and focus on a combination of bank retrenchment in a number of lending markets (as the panoply of national and international regulatory frameworks introduced since the financial crisis have forced banks to strengthen their balance sheets) coupled with the unprecedented low interest environment which has forced institutional money to hunt for yield in less liquid corporate and other debt instruments. Given this background this article summarises a number of the key themes emerging in the private debt markets last year and looks at some of the challenges that may lie ahead for the industry.
Wall of money
Whilst there is some evidence that the pace of fundraising for alternative debt slowed in the last quarter of 2015, the fact remains that very large sums of capital are being raised to invest in this asset class. In November 2015, BlueBay announced the closing of its second direct lending fund at €2.1 billion, some 160% bigger than its maiden direct lending fund. This theme has been repeated for a number of the larger private debt managers operating in the market, with ICG’s latest direct lending fund almost double the size of its June 2013 fund. According to data from Preqin, there are over 67 Europe focused private debt funds currently attempting to raise a combined amount of circa €48 billion.
‘Convergence’ (and weakening of documentary terms)
One of the consequences of this wall of money is that, whilst there were a number of macro concerns in the world economy during 2015 (and these have become increasingly pronounced in the first quarter of this year), 2015 was, in the main, a good time to be a borrower. At the top end of the market the competition between the high yield market (when it was open for business) and the loan markets and, more generally throughout the mid-market, the competition between banks and alternative credit providers has meant that borrowers (and their lawyers) have been able to ‘cherry pick’ terms from a variety of different products. This has led to what has been labeled a ‘convergence’ of terms as covenant-lite structures and terms from the US high yield and Term Loan B markets find their way into more and more European deals.
Whilst there is a view that private debt managers have ‘held the line’ in the European mid-market and continue to insist on financial and other maintenance covenants, there is evidence that this discipline has not been able to withstand the competition for deals, particularly as banks fight for market share. For example, in September 2015 debtXplained published research looking at sub €250 million debt transactions to determine whether the more aggressive features of larger transactions had impacted mid-market deals (where private debt tends to feature more significantly). The research found that whilst in 2013 over 90% of sub €250 million transactions featured the traditional four financial maintenance covenant package (leverage, interest cover, cash flow cover and capex), this had declined to less than 25% of transactions in 2015. Whilst a leverage covenant remains sacrosanct for most private debt providers in the mid-market, borrowers, sponsors and their lawyers have continually been able to make incremental improvements to documentary terms and this is a theme which is likely to continue into 2016 and until the current credit cycle definitively turns.
Governments are playing their part
Many European states have traditionally given banks a preferred status in lending transactions e.g. the requirement for bank licences in France and Italy in order to lend directly to corporates in those jurisdictions. In addition, in some countries only banks have been able to take certain types of security or benefit from certain withholding and other tax advantages. Whilst the credit crisis has led to the harmonisation of a number of financial regulations, there remain a large number of national regulations, particularly in relation to bank licensing requirements.
European governments have recognised however that in order for there to be a sustained economic recovery it is necessary to improve the mixture and overall resilience of funding sources to corporates and have therefore taken action to encourage this diversification. For example in Italy, where direct lending has traditionally been reserved to banks and certain financial entities registered with the Bank of Italy which are subject to regulatory and prudential provisions similar to those applicable to banks, legislation became effective in 2015 with the specific aim of “liberalising” the lending market so that securitisation vehicles as well as Italian insurance companies are now allowed to lend directly to Italian companies provided they retain a “significant interest” for the life of the transaction. The changes also enable collective investment schemes to invest in loan receivables effectively enabling them to also lend directly. Allied to this, the tax rules in Italy have been changed so that a withholding tax exemption (the withholding rate being 26%) will apply to payments of interest to certain non-resident lenders, including financial institutions established in an EU Member State and insurance companies established and authorised under the law of an EU Member State.
Banks versus alternative credit providers
It is important to recognise that whilst there is clearly a competitive threat to commercial banks from the variety of alternative credit providers now operating in the market and more generally by the deployment of more institutional capital in banks’ traditional markets, in many instances commercial banks and private debt managers are working together to structure transactions for the mutual benefit of clients. This structuring takes account of the fact that banks and private debt mangers may have different risk appetites and can therefore structure (through a unitranche arrangement) a ‘one loan’ solution for borrowers whilst at the same time apportioning the risk on that loan between themselves by virtue of an agreement between lenders or other intercreditor arrangement.
In addition, in all asset classes commercial banks will continue to be a key provider of hedging, working capital and other ancillary banking arrangements (often necessitating the use of bespoke super senior intercreditor arrangements). Whilst the co-operation between banks and private debt managers has in some instances been formalised into a joint venture arrangement, mostbanks and private debt funds seem to prefer a less formal series of alliances with a set of interceditor documentation pre-agreed to take to market thereby shortening deal execution time and minimising legal cost.
What happens when the cycle turns?
The three-year bull run in private debt has yet to be tested by a significant downturn in the credit markets and some have expressed concerns about how private debt managers will react when, inevitably, defaults in European corporate debt increase (and there is some evidence that this is now beginning to happen). The first point to make is that, in many instances, private debt managers have tended to operate bilaterally or in very small syndicates (and often write very significant cheques when compared to, say, a maximum hold for a bank of €20-25 million) and have not sold on their positions. This inevitably means that they will be very active participants in any debt restructurings as any losses they sustain will have a material impact on their fund’s performance.
Whilst it is a truism that each turn in the cycle begets predictions of ever more complex restructurings, it is inevitable that some of the intercreditor structuring on which private debt deals have been predicated in the last two to three years will make it harder and more complicated to restructure debt. This is particularly the case in unitranche transactions which have been structured using an agreement between lenders to which borrowers are not party. Based on recent court judgments in England, these structures could also provide an unpleasant surprise for ‘last out’ creditors in those structures who may find that, because the agreement between lenders is structured without a contractual nexus to the borrower, their subordinated position won’t necessarily guarantee them their own separate class should a scheme of arrangement be used to cram down dissenting junior creditors.