European Direct Lending

Why invest in European Direct Lending

Growth Potential: The European direct lending market is growing as traditional banks reduce their lending activities due to regulatory constraints. This expansion offers opportunities for attractive returns in an evolving market.

Diversification: European direct lending provides exposure to a diverse set of industries and geographies, helping to diversify an investment portfolio beyond North America.

Attractive Risk-Adjusted Returns: European direct lending often features lower interest rates compared to North America but can offer stable, predictable income streams. Customized deals and more conservative terms can also mitigate risks.

Less Competition: Compared to the mature U.S. market, Europe has fewer established players in direct lending, which may present opportunities for more favorable deal terms and less competition.

Economic Stability: Many European countries offer stable economic environments with strong legal frameworks, which can provide a solid foundation for lending investments.

Growing Market: The increasing involvement of private equity and the shift away from traditional bank lending are driving demand for direct lending, presenting potential for capitalizing on this market evolution.

What are the main risks of European Direct Lending

Regulatory Complexity: The diverse regulatory environments across European countries can create challenges. Variations in legal frameworks and compliance requirements can increase operational complexity and cost.

Economic Variability: Economic conditions can vary significantly across Europe. Economic downturns or regional instability in certain countries can affect borrowers' ability to service debt.

Currency Risk: Investing in multiple European countries involves exposure to different currencies. Fluctuations in exchange rates can impact returns and increase risk.

Deal Quality: The European direct lending market is less mature, which may lead to variability in deal quality and terms. Investors need to carefully assess each deal’s risk profile.

Market Competition: Although less competitive than North America, the European direct lending market is becoming more attractive, potentially leading to increased competition and pressure on returns.

Borrower Credit Risk: European borrowers may have different credit profiles compared to North American counterparts. Inadequate credit assessment or differing borrower behaviors can impact loan performance.

Legal and Enforcement Risks: Legal systems and enforcement of creditor rights can vary across countries, affecting the ability to recover loans in case of default.

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.

Question 1.  What is driving the evolution of the opportunity set in European Direct Lending?

Apera Asset Management

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.

AlbaCore Capital Group

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.  

KKR

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.