European Direct Lending Booms As Other Markets Dislocate

31st August 2022   |   5 minute read

We are pleased to share the following article, by Francesca Ficai from Pitchbook LCD. Read more in the full article on the LCD terminal here:

Dislocation in the syndicated loan and bond markets is accelerating the spread of private credit across Europe’s leveraged finance space, allowing private debt players to step into deals that would have been obvious targets for syndicated lenders before Russia’s invasion of Ukraine, and creating innovations around unsold positions on bank underwriters’ balance sheets.

“Banks are now looking at their backlogs rather than chasing new deals,” one debt advisor said. This focus on existing positions is allowing direct lenders to build on their progress in the immediate aftermath of the initial Covid shock in 2020, when they were able to continue to support new deals as other lenders paused. What’s more, further innovations are now allowing direct lenders not only to step up and provide enormous unitranche financings, but also to take the role of syndication investors.

Size matters

This broader market for private debt has led to larger companies and deal sizes. In the first quarter of 2020 the average size for European direct lending deals was €90 million, based on LCD data, but by the second quarter of 2022 it had increased almost tenfold to €861 million. The average annual EBITDA totals factoring into those deals have also increased, rising from €21.4 million in the first quarter of 2020, to €50.3 million by the second quarter of 2022.

“If you break private debt down it largely falls into two periods of time,” says Anthony Fobel, CEO of Arcmont Asset Management. “First, for almost the first eight or nine years in Europe, private debt was really about bank replacement. After the financial crisis, the banks had lots of problems lending to mid-market businesses, and private debt filled that vacuum. Second, in the last two-to-three years, private debt has increasingly started substituting the public debt markets.”

But public debt substitution only works for larger firms, which plays into the hands of bigger funds. “It’s only really the larger firms that can do the public debt markets substitution deals,” Fobel adds. “You need to be able to underwrite a loan of anywhere from €400 million to €1 billion, which means you need a big fund to do it. Otherwise, you’re putting your investors into very concentrated positions and often your fund documentation doesn’t allow you to do that. I would say we are one of four or five players in the European market that can do these deals.”

This year’s roughly €4.1 billion-equivalent financing for The Access Group is the biggest unitranche yet agreed in Europe, while 2022 also hosted numerous jumbo unitranches such as Corden Pharma, with a €1.5 billion transaction. Of the 20 largest direct lending deals tracked by LCD since 2015, 12 were financed in 2021 and the first half of 2022 combined.

Risk removal

More recently, private debt is being called on to help banks remove risk from their balance sheets. CVC-backed Gaming1, for example, is understood to be talking to private debt lenders about a selldown of its €300 million term loan after syndication of the credit stalled and failed to close earlier in July. The deal was presented on a call on June 23, and replies were due July 6 via joint physical bookrunners BofA Securities and Macquarie.

Private debt is also increasingly the first stop for sponsors now that many banks are effectively closed for new underwriting until they’ve dealt with their hung positions. This week, for example, Astorg and Epiris agreed to buy Euromoney Institutional Investor in a £1.66 billion deal backed by an Ares-provided financing. The deal values the financial publisher and data group at £14.61 per share, or 20.2 times Euromoney’s EBITDA for the 12 months to March 31, 2021.

“At the moment, there is a delay or slowdown in M&A while buyers and sellers are adjusting their pricing, but at the same time the liquid markets are effectively closed. So, all the deal flow that was going to go to the liquid market is being taken by private debt,” says Arcmont’s Fobel. “There is currently a very large volume of public market deals that now cannot be done that are coming our way.”

Of the European direct-lending transactions tracked in the second quarter of 2022, 77% (by deal count) were acquisition-related, according to LCD, which is up from 68% in the first quarter. Breaking down the acquisition-related direct deals, buyouts accounted for a 58% overall share in the second quarter of 2022, which is down slightly from 64% in the first quarter.

The market is changing in other ways too, and private debt also has to contend with a more cautious approach from sponsors as they deal with rising inflation and interest rates, as well as stock market volatility. The question for lenders is whether this is the end of a cycle, or just a temporary disruption.

Against this backdrop there was a decline in sponsored activity in the second quarter of 2022, with 73% and 27% of the European direct lending deal count coming from sponsored and non-sponsored issuers, respectively, versus 82% and 18% in the first quarter.

Sector selectors

Meanwhile, there are signs that lenders are looking to safer sectors. Computers & Electronics (which accounted for 20.8% of the number of deals tracked by LCD in the year to June 30), Healthcare (18.8%), and Professional & Business Services (12.5%) are the most sought-after sectors, as they are the least-cyclical and the most protected from potential supply chain issues, sources say.

“We look for very resilient businesses,” said Arcmont’s Fobel. “In a way with larger deals there is more chance to invest in higher quality businesses. When we have had issues, it tends to be generally smaller businesses. We want to focus on sectors like IT services, business services, software, healthcare and education, which are typically non-cyclical sectors.”

Looking at the main regions for direct lending markets observed in the data tracked by LCD in the year to June 30, the top three are the U.K. with a 33.3% deal share, France with 18.8% and Germany with 22.9%. Notably, there was a slight uptick in the Dutch market, which rose from a 6.8% share in full-year 2020 to 8.3% in the first half of this year — mainly due to the fact it is one of the fastest-growing markets in Western Europe, which together with Belgium (2.1%) has become an expanding hunting ground for pan-European direct lenders.

In all though, it looks as though the private lending market is living its best life. “This is a highly attractive market environment, particularly for the larger players because the supply/demand dynamics are in our favour,” Fobel said. “Pricing has improved to reflect base rates and market volatility, leverage multiples have come down so these businesses have sensible levels of leverage to service the increased cost of debt, we are getting better covenants and other protections in our documents and, finally, these are large high-quality businesses.”

“During extended periods of caution, the markets will often add an illiquidity premium to pricing for certain types of credit,” said Aymen Mahmoud, partner at MWE. “That premium often normalises as economic certainty returns.”

But such trends do not mean public financings led by banks are going to disappear, concludes a source. “Direct lenders will not replace banks altogether in the long run,” stressed one lender. “Rather, private lenders will co-exist with the broadly syndicated market in the same way that private equity has co-existed with the stock market.”

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