Written By: Simon Perry
A sharp decline in bank lending to medium-sized companies is creating new opportunities for both specialist direct lending providers and global investing institutions attracted by the positive risk and return profile offered by the loans sector. Simon Perry of Alcentra looks at the options presented
The 2008 global financial crisis triggered a wave of new banking regulation that had unintended consequences for corporate lending by banks to so-called middle market businesses. These companies, usually defined as those that have an enterprise value of less than £500 million, have subsequently found it increasingly difficult to access bank loans critical to their business development.
European banks facing legislation such as the Basel III capital requirements have dramatically drawn back from middle-market lending, due to regulatory capital pressures which now penalise banks for longer-dated lending to smaller companies and restrict the size of loans they will offer to a single borrower. This pressure – coupled with a historical lack of non-bank lenders in Europe – has encouraged the development of alternative lenders.
As the European economy has recovered, the need for capital among middle market businesses has grown and private lenders have stepped in to fill the void left by the banks. We think this is a structural rather than cyclical change in the business and that pressure on banks to maintain well-capitalised balance sheets will continue.
There is a market precedent for this. In the US, banks acted in a similar way over 15 years ago when its regional banks merged into national banks in the aftermath of the domestic savings and loans crisis. The result was a rise in the threshold of company size required to get the banks’ attention. That triggered a growth in private lenders replacing the banks as the main lenders to the middle market sector. They remain the principal provider of finance to this sector today.
The type of companies specialist direct lending companies support varies widely and we lend predominantly to businesses located across Europe. Most of our activity is focused on the core of developed Europe (UK, France and Germany) to companies with an enterprise value of between £50 million and £250 million via senior debt, junior debt and unitranche financing.
Global investors, including many pension funds faced with difficult asset allocation choices, have become increasingly attracted to opportunities in the loans market. Volatile equity markets driven by political decisions rather than economic fundamentals, have made the generation of returns from this asset class increasingly hard to predict.
This has caused investors to seek more predictable sources of return, with fixed income markets a major beneficiary of this. A typical UK pension fund used to be up to 70% invested in the equity market with the balance in fixed income and property. Now allocations to public equity markets as low as 20% are not uncommon and fixed income has risen in some cases to represent over half the portfolio.
Initially investors allocated fund to investment grade corporate credit and government bonds, but quickly the weight of money entering the sector caused yields to compress. In a search for yield, we have seen investors moving down the rating spectrum to look at high yield and bank loan markets, but again, the momentum of the move has caused spreads to tighten and deal terms to weaken, with covenant-lite now being an everyday feature of European senior secured loans.
Consequently, those investors who don’t need immediate access to their money are looking for ways to improve returns by extracting a liquidity premium. This has driven investors to consider less liquid, private asset classes like real estate lending, lending to infrastructure and our own particular specialty, lending directly to middle market corporates.
The objective of investing in these asset classes is to generate returns of 8% to 10% while retaining the benefits of a secured investment by exploiting a structural change in the market. The cost is the need to accept that investment capital will be locked up for up to six years.
While investments in this sector are not risk free, their risk level should not be overstated. Investing via a senior secured asset class means that even if there are defaults investors are very high up in the capital structures so recovery rates are usually high.
In addition to strong potential returns, an added benefit of investing in loans to the middle market sector is that pension fund investors are directly supporting an area of the business community which stimulates broader economic growth.
The European direct lending market is growing fast and we have seen a number of new entrants come into this sector over the last year. The non-bank share of the lending market has risen from less than 5% to closer to 15%, so we have seen a lot of growth. But the US market is closer to 80% non-bank funded, so there is still a lot of scope for the asset class to grow.
We see our pipeline of lending opportunities growing and both returns and fees remaining stable for the foreseeable future.
Indeed, while liquid asset classes continue to offer paltry returns, we believe investors will continue to benefit from providing secured private debt to middle market investors, filling the void left by the banks and helping to strengthen the economic recovery in the process.
The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When investments are sold, investors may get back less than they originally invested.
This is a financial promotion for Professional Clients. This is not investment advice.
Any views and opinions are those of the investment manager, unless otherwise noted.
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