I have always found the mid-market lending narrative of European direct lenders (a sub-segment of private credit) rather vexing. They consistently assert that over recent years they have eaten the banks’ lunch in midcap lending because the banks (they say) have continued their headlong retreat from this segment.
The banks, meanwhile, are mystified as to how the direct lenders can claim any such thing and that they (the banks) remain committed to supporting the needs of their mid-market clients and have the capital to continue doing so. The banks say they rarely if ever encounter direct lenders as they go about their day-to-day mid-market/lower mid-market corporate lending origination.
As everyone continues to wax lyrical (and ad nauseam) about the power of private credit to change the world, this back and forth between banks and direct lenders has become tedious.
Taking half a step back, it’s true that the banks have been forced, through robust capital, liquidity and leverage regulations put in place since the global financial crisis, to be more risk-averse across their businesses. That includes their lending businesses. And from a profitability standpoint, banks have been more forensic about calculating the returns they make on their corporate relationships and have exited those that don’t make financial sense, in the quest to improve return on equity at bank level.
But on the basis that banks have backed out of lending relationships that are predominantly very high-risk or which have a non-standard, special-situation feel to them, that’s arguably a reasonable outcome and one which bank regulators presumably approve of. Or perhaps better put, that’s the outcome they have engineered, from their standpoint of protecting financial stability and reducing systemic risk in the banking sector.
Broadly speaking, the fact that the banks are less willing to fund very high-risk companies for what many would see as the right reasons has provided the perfect marketing platform for private credit providers, keen to attract institutional investors, aka limited partners (LPs), into their direct lending funds. And they have grabbed that marketing opportunity with both hands.
High-risk, highly leveraged
I read a Q&A with a direct lender the other day regarding his firm’s current mid-market fund and he referenced average expected gross returns of around 12%. Those returns will be boosted to some extent by higher interest rates. But even so, those returns are punchy and driven by leverage – an average of 4.5 times Ebitda (earnings before interest, taxes, depreciation and amortization) in the Q&A I read.
So, telling the story in another way, direct lenders in mid-market corporate lending focus on companies that the banks no longer want to lend to. And they have been all too happy to ply their trade in a corner of the market that can offer them the high returns their LPs demand. Actually, this is one of the few places they can generate those kinds of returns. That and leveraged buyouts, or in areas like mezzanine and distressed.
Higher interest rates may have altered the picture somewhat; but to the extent there’s been any shift in focus to higher-earning opportunities in less risky areas of the corporate landscape as rates and margins have shifted upwards, that shift will reverse as rates start to fall.
So, there you have it: in straight lending, direct lenders target high-risk highly leveraged companies that can offer them double-digit returns. Standard midcap bank lenders just don’t play in that space as standard. And that’s the story here. Banks and direct lenders occupy and engage at different points of the midcap corporate landscape.
In terms of client alignment, a direct lender’s clients are predominantly financial sponsors on one side and LPs on the other. The company is a means to an end. For the banks, the client is the company. Period. Even if they maintain a sell-down, originate-to-distribute syndicated business model, the banks maintain tight relationship groups at the core of which is lending, but which includes a suite of ancillary products and services. Loan pricing will be adjusted around the level of ancillary business a bank’s client can offer. Direct lenders are financing only; they neither seek nor can offer ancillary services.
In fact, direct lenders in the corporate mid-market is many cases something of a misnomer. Because they dedicate pretty much all of their time to working with financial sponsors. A significant chunk of their deal flow is funding leveraged buyouts. This is where private credit has encroached successfully onto the banks’ territory (although the banks have started to fight to win back clients).
From the perspective of keeping the European banking sector risk-averse and preventing an overhang of risky assets building up, this is a logical outcome from the supervisory perspective. The European Central Bank’s banking supervisory arm has gone to extraordinary lengths to get banks to reduce their leveraged finance exposure. The credits the banks don’t want to fund were always going to shift into the unregulated shadow banking arena (which is where private credit lives).
While in the US, highly leveraged high-risk financing can go to private credit, a deep and functioning high-yield bond market, private placements or to business development companies (a type of specialty financing vehicle), Europe lacks viable non-bank alternatives. Private credit has taken up the slack here.
The problem, of course, is what happens if – some would say when – the private credit asset class enters into a downward spiral of asset-quality deterioration. On the surface, the banks won’t be affected. Except they might yet. Private credit and banks may not compete loan-for-loan at the corporate mid-market origination level, but private credit providers have been borrowing more and more from banks on a secured basis, putting up underlying portfolio loans or capital calls on LPs (so-called subscription lines) as collateral.
What’s worrying regulators – with reason – is the growing inter-connectedness between private credit and the banks. Now that wasn’t part of the playbook.
