In an era of rising correlations, institutional investors are increasing their exposure to alternative asset classes. At the forefront of this trend is direct lending, where institutional investors can access sustainable yields and sources of uncorrelated returns.
Europe’s emergence as a direct lending market is still relatively recent and it is vitally important to understand the rapid evolution of the market. The European small and medium-sized enterprise (SME) lending market has traditionally been the preserve of the banks, which have vast networks and strong relationships for originating deals in this sector.
But the SME funding landscape changed dramatically in the wake of the global financial crisis amid growing regulatory pressure – and investment firms filled a gap left by European banks unable to provide sizable loans to SMEs.
Today, the market is disintermediating gradually in Europe even though the banks remain providers of the vast majority of loans to mid-market companies and are the biggest lenders in their home markets. Recently we have seen some banks that had exited the market re-entering, regaining market share as their balance sheets have improved since the financial crisis.
Growing opportunity
Nevertheless, there is an increasing opportunity for direct lenders in Europe: funds based on the continent that run direct lending strategies raised more than €20 bn ($23 bn) in 2017, up from €9 bn the previous year. Direct lending now accounts for 10 percent of Europe’s business loan market.
Given the prominent role of banks in business lending, direct lenders seeking attractive SME loans benefit from having robust relationships with conventional lenders. But establishing such relationships can be tricky (though still beneficial) because direct lenders will never know the borrower as well as the local bank that has provided its loans over the long term. Moreover, there are vast regulatory, legal and cultural differences throughout Europe’s business landscape, and this has hindered the pace of disintermediation in the European SME lending market.
Direct lenders have a choice when it comes to accessing the European SME lending market. They can establish their own on-the-ground, geographically dispersed origination teams to foster relationships with debt advisers, private equity firms and regional banks.
Challenged by the geographical scope of SMEs located across the continent, however, origination teams are unlikely to tap the entire suite of lending opportunities available in the region. As such, lending opportunities will be limited – typically to loan opportunities that banks have rejected.
Alternatively, direct lenders can partner with local and regional banks by entering non-exclusive or exclusive co-lending agreements. Under non-exclusive agreements, local and regional banks disclose loans to direct lenders in order to plug funding gaps they cannot cover. This means direct lenders see some – but not all – of a bank’s deal pipeline. What’s more, many of these opportunities arise because the bank is unhappy about holding the majority of the loan on its balance sheet.
Under exclusive co-lending agreements, participating banks are legally obliged to disclose every deal they originate, within broad parameters, to direct lenders. That means the direct lender has visibility of the bank’s entire lending pipeline, and thereby has access to the best loans available.
Credit pickers
By entering an exclusive co-lending agreement, direct lenders gain the ability to choose the right loans and are therefore credit pickers rather than forced lenders. The different origination strategies used by direct lenders to access the European SME senior-secured market provide varying levels of deal flow. On-the-ground, geographically dispersed origination teams and non-exclusive co-lending agreements provide limited – and infrequent – access to SME loans.
These deals are often second-tier transactions that have already been refused by banks’ exclusive or favored partners. Meanwhile, the exclusive co-lending agreements provide direct lenders with a rich pipeline of high-quality loans.
At Hermes, we have overcome regulatory and cultural challenges in Europe by establishing a set of exclusive co-lending agreements to cover SME financing with four banks that have a broad geographic scope: Danske Bank, DZ Bank, KBC Bank and Royal Bank of Scotland. These agreements give us access to the best deals to invest in on behalf of investors.
With European growth on a strong trajectory, the demand for SME loans should stay strong for some time but it is vital to remain cognizant of the challenges of investing in an area with diverse regulatory and cultural challenges. By leveraging the expertise of local operators to successfully navigate these challenges and tap into regional markets, investors can successfully unlock the opportunity in European loans.
Patrick Marshall is head of private debt and CLOs at Hermes Investment Management
