An allocation into direct lending can provide a diversified source of higher, less volatile returns over a longer-term time horizon.
Since the 2008 financial crisis, heavier regulatory burdens have resulted in the need for greater capital requirements and stronger risk management for banks.
These evolving dynamics have led to a structural shift in the European lending landscape as banks retreat from the market. But while the role of banks as lenders has reduced, the borrowing requirements of businesses remains buoyant and growing.
This in turn has resulted in an increasing opportunity set for direct lenders – asset managers offering direct lending solutions who have stepped in to fill the lending gap left by the banks.
Fig. 1- European Bank Loans to Corporates has Declined
Source: ECB, our statistics – banks’ balance sheet – total loans to corporates November 2016
The role of a direct lender can be seen as twofold. The first is to supply funding to businesses such as small-to-medium-sized enterprises (SMEs) seeking bespoke lending solutions. The second is to offer investors an alternative investment capability with an attractive risk-adjusted return profile.
Fig. 2 – Non-Bank Lending Deals in Europe are Increasing
Source: Deloitte Alternative Deal Tracker Q4 2016
The private debt market is not a new phenomenon, with sub-asset classes including mezzanine debt, special situations, real estate and distressed debt firmly established in the marketplace. However, the sub-asset class of direct lending in Europe is a more recent occurrence because it evolved as a result of the financial crisis.
While the concept is embedded in the US lending landscape, where direct lenders sit comfortably alongside banks as a source of financing, in Europe direct lending is still in its relative infancy. Nevertheless, it is growing in popularity and we believe appears here to stay.
A Long-Term Investment Allocation
In a world of low yields in traditional fixed income, direct lending funds offer an attractive alternative source of return on a risk-adjusted basis when considered as part of an overall portfolio allocation. Consequently, institutional investors are showing increasing interest in these less-liquid strategies.
As central bank rhetoric turns increasingly hawkish, fixed income investors are looking for solutions that can provide protection from rising rates and market volatility. The floating rate features of the investment instruments within a direct lending fund mean they are insulated from moves in interest rates, while the illiquid profile provides protection from mark-to-market volatility. Investors are compensated for the latter with an attractive illiquidity premium, which leads to higher yields than liquid investments. The illiquid nature of the investment meanwhile sits well with the longer-term investment horizon of many institutional investors.
The capital and risk profile of the asset class can also be seen as attractive. Depending on the asset manager, debt can be positioned higher up the capital structure, which can offer greater protection against default.
A Focus on Origination
While we believe the opportunity set across Europe continues to grow in its appeal, how investors execute their investment allocation is something that should be taken under careful consideration.
We believe a strong team of highly-skilled, dedicated investment professionals focused purely on structuring and executing the best deals is key to a successful strategy in this space. Lenders can have a direct impact on the businesses to which they loan money, as well as a more direct influence on the outcome of their investment.
Having a local presence in these markets is also vital in giving a lender the ability to invest into directly-originated transactions, as well as a greater understanding of cultures and jurisdictions. Therefore, we would encourage those considering an allocation into the direct lending space to approach a dedicated service provider.
From a lenders point of view, we believe the European middle-market is a particularly attractive segment of the market, with an estimated 100,000 businesses generating approximately €7 trillion in annual revenues and enjoying an estimated 4.9% annual revenue growth (Source: Amadeus BVD, as of 5th August 2016). The size and continual development of this market means there are ongoing requirements for new sources of debt capital.
Here to Stay
The European direct lending market emerged as a result of the ensuing chaos from the financial crisis. Yet we believe it is not a short-term trend. The financial crisis highlighted inefficiencies in the way businesses source capital, with the realisation thereafter that the system actually benefits from a diversified range of funding options. As we have witnessed in the US, we believe direct lenders can and do have a long-term role to play alongside banks.
This trend is being underpinned by a wave of changing regulations across Europe, making it easier for businesses to source capital from direct lenders. In the last two years Germany and Italy have relaxed the lending laws to allow non-banks to provide financing solutions. At the same time, we are witnessing tighter controls restraining bank lending activity still further.
Taking the US market as an example, we believe over the long term funding in Europe will be increasingly provided by the institutional finance market. Demand from SMEs is outstripping supply, which is providing a healthy technical backdrop and underpinning the long-term opportunity set.
In our view, direct lending appears here to stay. An optimal trend for both lenders and borrowers.
Past performance is not a guide to future performance. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Where references are made to portfolio guidelines or features, these may be subject to change over time and prevailing market conditions.
The prices of fixed income securities fluctuate in response to perceptions of the issuer’s creditworthiness and also tend to vary inversely with market interest rates. The value of such securities is likely to decline in times of rising interest rates. Conversely, when rates fall, the value of these investments is likely to rise. Typically, the longer the time to maturity the greater are such variations. A Fund investing in fixed income securities will be subject to credit risk (i.e. the risk that an issuer of securities will be unable or unwilling to pay principal and interest when due, or that the value of a security will suffer because investors believe the issuer is less able or willing to pay).
Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.
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