Direct Lending: What’s Different Now?

[Pages:20]Implementation Insight

Direct Lending: What's Different Now?

Contents 03

Why Read On?

04

Part One: Is now a good time to invest in private debt?

11

Part Two: New manager selection challenges

bfinance is an independent, award-winning consultant that provides investment implementation advice to institutions around the globe. With highly customised processes tailored to each individual client, our aim is to empower investors with the resources and information to take key decisions. The team is drawn from portfolio management, research, consultancy and academia, combining deep specialist expertise with global perspective. bfinance has conducted more the 800 engagements for over 300 clients in 32 countries. The firm is headquartered in London, with offices in Paris, Amsterdam, Munich, Montreal and Sydney.

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03 bfinance Direct Lending: What's Different Now? March 2017

Why Read On?

With global institutional appetite for private debt

senior debt within these vehicles, the senior portion is increasingly dominated by unitranche rather than traditional core

remaining strong into 2017,

senior secured lending. Furthermore,

the pile of dry powder chasing corporate direct lending has

unitranche loans ? which can take many forms ? appear to be moving away from their original simple structure with lenders

never been higher.

taking on more risk in the capital stack and

higher multiples (page 7).

Every week sees the release of a new industry white paper designed to draw further investment. The post-GFC `story' underpinning the opportunity was powerfully simple and intuitive, especially in Europe where bank retrenchment and CLO

While some institutions are keen to stretch for returns in the current climate, recent bfinance consulting work reveals a growing appetite among pension funds and insurers for purer senior debt funds. Many existing products prove too

market shrinkage were particularly marked. risk-seeking for their tastes. We would

encourage such investors to focus on

Yet this strong simplicity hides a multitude the nature of the senior debt as well as,

of changes and challenges, which investors if not more than, the proportion invested should consider carefully when approaching in subordinated debt (page 15).

this asset class. We are frequently asked: "is now a good time to invest?" While the answer may still be "yes," a deep understanding of what's under the bonnet will be key to successful implementation.

An additional notable trend in investor appetite is evident from manager selection engagements. European asset owners are increasingly keen to invest in US private debt (page 16 ). Many of

What we call "senior" has become somewhat riskier over the past four years. In part, this has been driven by spread compression, particularly in the upper-mid market (>$75 million EBITDA) space. Leverage (Debt-to-EBITDA) on senior direct lending has crept up as managers seek to keep IRR expectations

these have so far steered clear of this very different market due to the greater leverage at fund level, unfavourable taxes and currency hedging costs involved. Yet asset owners should pay close attention to the many differences in how US and European managers actually generate returns (page 14).

on track, while deal terms for lenders have eroded (page 10). Yet the most significant factor may be the changing composition of senior debt funds.

Monitoring the latest developments in private debt continues to be a high priority at bfinance. We hope that this paper proves useful to investors that are

For instance, although there has been a minor style drift from subordinated to

contemplating or already active in this rapidly evolving sector.

Latest News

Nearly 30% of the senior debt products covered in bfinance's last five private corporate debt searches represent the manager's first fund of this type, illustrating the speed at which this universe is evolving. Additional players continue to come to market, such as BC Partners' new vehicle and Apera Capital, founded by Klaus Petersen (ex-BlueBay) and David Wilmot (ex-Babson). According to Preqin, closed-ended private debt funds raised $73.8 billion in 2016, falling considerably short of 2015's $95.1 billion figure. "Direct lending" funds also raised less money, at $43 billion versus $54 billion in 2015. However, the level of dry powder reached a new peak at over $220 billion. We expect significant performance dispersion between upper and lower quartile managers in this more competitive environment. In total, bfinance worked on private debt mandates worth over $1.25 billion in calendar year 2016, of which nearly $930 million comprised corporate lending. This volume represents an increase of well over 100% versus 2015.

04 bfinance Direct Lending: What's Different Now? March 2017

Part One: Is now a good time to invest in private debt?

The story behind the expanding direct lending opportunity, particularly in Europe, has become an industry leitmotif.

The financial crisis of 2008 and ensuing tighter regulation combined to produce a reduction in bank lending to companies across European markets as well as a significant drop in CLO issuance. The result was a severe decline in credit availability. Meanwhile, modest economic recovery and rising M&A volumes subsequently boosted borrower demand. The result: private debt managers gained market share relative to banks in Europe and the provider universe, discussed in detail later in this paper, continues to evolve and expand.

For investors, the asset allocation rationale proved highly effective during an era when public fixed income yields have remained historically low and private equity allocations - the other major source of new institutional private debt commitments have been hard to fill.

Yet the current climate is more nuanced. This is not 2012. While 2016 private debt fundraising was lower than the previous year (see page 12), the volume of dry powder sitting in these funds ($223bn as of June 2016) reached a record high (Figure 1). In 2017 the risk/reward equation, while still highly attractive in relative terms, is somewhat less favourable than it was four years ago.

Jargon buster: Leveraged Loan vs Direct Lending

"Leveraged Loan" (LL): larger banksyndicated loans; more liquid and loweryielding. Default rates were 3-4% over the last 10 years. Market size (according to CS): $1014bn in US, 170bn in Europe at April 2016.

"Direct Lending" (DL): loans made directly to borrower by a sole lender or group (club deal); more illiquid, higher yielding and (usually) smaller. Default rates 6x

08 bfinance Direct Lending: What's Different Now? March 2017

Today, practitioners take pains to argue that the growing pile of dry powder targeting direct lending opportunities won't impact dealflow or harm prospective returns...for them, at least.

It is worth rattling through some of the points that managers have recently offered in favour of continuing expansion.

1: Overall corporate lending is still lower than it was prior to the financial crisis. This analysis holds from several different perspectives including new-issue leveraged loan volume (S&P), estimates on outstanding corporate loan amounts (ECB) and more. The "mega deals" that characterised 2006-7 are also still something of a rarity today.

more bespoke and creative models, including a recent spate of manager/bank unitranche financing partnerships where the bank may issue a revolving credit facility and/or hold a portion of the debt, such as SMBC/Park Square and Ares/ Varagon. Bank syndication is also in a very healthy state relative to 2008, when the liquidity crunch made it harder for banks to offload debt (especially mezzanine) to other lenders, and is the source of much manager dealflow. The relationship between banks and alternative lenders is more often symbiotic than competitive.

Several commentators have suggested that we may see a reorienting of the competitive position of banks under President Trump. In our view, any such developments are likely to have a minimal effect: banks have continued to be highly active in corporate lending in one form or other throughout the past decade and will remain so.

2: Additional regulations could drive a continuing growth in managers' market share. These include: Basel III and its more stringent capital requirements for banks, for which the compliance date is 2019; new US Federal Reserve Loan Guidelines that make banks less likely to refinance the $180bn-240bn of existing loan structures at >6x leverage; new guidelines for US CLO managers, similar to the European retention rules that have reduced European CLO issuance.

3: Private equity firms are holding large volumes of dry powder. This capital (Figure 5) will need to be deployed, supporting strong levels of LBO/ M&A activity and thus driving sustained high demand for sponsored loans. That being said, multiple managers express concerns that the number of refinancings and dividend recaps will decline, offsetting the healthier M&A-related sector. For reference, M&A-related transactions make up 51% of leveraged loans in the US and 57% in Europe, according to S&P.

That being said, banks have pressed to regain market share. They've explored

Figure 5: Dry powder in mid-market buyout funds (USD billion)

150

100 50

0

Dec `00 Dec `01 Dec `02 Dec `03 Dec `04 Dec `05 Dec `06 Dec `07 Dec `08 Dec `09 Dec `10 Dec `11 Dec `12 Dec `13 Dec `14 Dec `15 Jun `16 Feb `17

Source: Preqin

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