European Direct Lending
In Europe, direct lending is less mature than in North America but growing, as banks historically dominated corporate lending.
Asset Class Leaders
Why invest in European Direct Lending
Pros
Cons
What characterizes European Direct Lending?
- Industry/Sector: Typically, generalist across all industries and sectors, though some managers have an industry/sector focus.
- Instruments: First Lien, Second Lien, or Unitranche term loans, which blend elements of senior and subordinated debt into a single loan with a unified interest rate. European direct lending frequently involves bespoke deal structures due to market fragmentation. Unitranche loans and senior secured loans are common, but custom terms are often tailored to specific borrower needs.
- Maturity Profile: Generally, ranges between five and seven years although given refinancings, the average time outstanding typically falls within the three to four years. In contrast, fixed rate High Yield bonds usually have maturities exceeding seven years resulting in credit and duration risk.
- Credit Quality: Moderate/Higher risk. Borrowers typically have credit ratings that are below investment grade.
- Interest Rate risk: None (floating rates) / Moderate (floating/fixed rates). Typically, interest rates for these loans are priced as a spread above a floating rate reference rate typically linked to benchmarks like Euribor. European direct lending typically features lower interest rates compared to North America.
- Borrower Size: Middle Market. Direct lending primarily involves providing senior debt to lower (EBITDA: $5mm-$25mm), middle (EBITDA: $25mm-$75mm) and upper (EBITDA: $75mm plus) middle-market borrowers. More recently, the upper end of the borrower size has increased, nearing the lower end of the syndicate loan market.
- Return Profile: Derived from contractual yield, arrangement fees, original issue discount (OID), prepayment and covenant- reach fees.
- ESG: Impact / Positive Screening / Negative Screening. There is a strong and growing emphasis on ESG criteria in European direct lending, reflecting broader market trends toward sustainable finance and regulatory pressures.
Manager Q&A
Question 1
What is driving the evolution of the opportunity set in European Direct Lending?
The market is evolving beyond its historic mid-market focus to become an important source of funding for larger corporates, an area of the market that the AlbaCore team have over twenty years’ experience lending to. In contrast to the syndicated market, private credit can provide sponsors with greater flexibility in terms and certainty of execution, making it a compelling alternative for sponsors. While M&A activity, the primary driver of the market, has been limited on the back of the economic backdrop last year, AlbaCore expects activity to pick up. Sponsors, according to S&P Global Market Intelligence, are sitting on a record level $2.59 trillion of dry powder and a record $2.8Tn in unsold investments. Banks continue to retreat and unless loan and bond market participation recovers to pre-Covid levels, there is likely to be a large funding gap that private lenders can capitalise on.
Since 2010, the alternative financing market for mid-market companies in Europe has grown significantly, driven by structural changes. Basel II & III reduced bank appetite for lending activities, whilst Solvency II has increased institutional investor demand for private loans. The AIFMD of 2011 gave scope for alternative lenders to provide financing without a banking licence, enabling them to step in where the banks were pulling back, to give institutional investors the exposure they sought.
Regulatory capital pressures have had most impact upon reducing bank lending activity in the European Lower Mid-Market (“LMM”) . The absence of a bond market as an alternative funding source has reinforced private credit managers as the core supplier of finance in the LMM space in particular.
Private debt in Europe has been growing at a CAGR of >20% from 2010-2022 with significant scope for further growth – bank loans still represent 86% of the European financing market compared to just 21% in the US.
The unreliability of the syndicated market has seen private credit taking market share over the past ~2 years. Issuers that previously would have used the syndicated market have begun to use the private credit market for the reliability of capital at only marginally more expensive rates. This has been most prominent in the upper middle market (EBITDA of €50m+). There has been a large increase in jumbo (€1bn+) private loans completed during 2023, with over half of all historical jumbo loan issuance coming to market in 2023 alone. As a result, we have seen the average EBITDA across our portfolios increase, with the weighted average EBITDA for our latest European Direct Lending Fund now at over €200m. Looking ahead in 2024, we expect to see high quality deals continuing to come to market with a pickup in M&A activity given the large levels of PE dry powder.
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