In an era of rising correlations, institutional investors are increasing 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. In his latest insight, Patrick Marshall, Head of Private Debt and CLOs at Hermes Investment Management, discusses how to successfully tap expanding opportunities in European direct lending.
Understand the rapidly evolving landscape
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: they have vast networks and strong relationships for originating deals in this sector. The SME funding landscape, however, 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 sizeable 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 which had exited the market now re-entering, regaining market share as their balance sheets have improved since the financial crisis.
Nevertheless, there is an increasing opportunity for direct lenders in Europe: funds based on the continent that run direct lending strategies raised more than €20bn in 2017, up from €9bn the previous year. Direct lending now accounts for 10% of Europe’s business loan market.
Overcome cultural and regulatory challenges
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 although beneficial as 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 the continent’s business landscape, which has hindered the pace of disintermediation in the European SME lending market.
Germany has a competitive, bank-dominated market served by many small regional lenders and a few national lenders. These banks have a close understanding of the domestic landscape and consequently, access numerous origination opportunities. Regulation is generally restrictive, but a new framework for lending by alternative investment funds was established in 2016.
France is a developed market, but it boasts fewer SMEs than Germany. The main barriers to entry include the country’s code of law, which is less creditor friendly than many countries in Northern Europe, and the difficulty of originating good deals in a very competitive, bank-led market.
The Netherlands boasts good deal flow, a vast range of mid-market companies, and is considered a relatively open and developed market. Deal flow is weaker in Belgium, which has historically been a bank-led jurisdiction.
Meanwhile, in the Nordics the private debt market is at a nascent phase of growth, with little disintermediation.
Establish exclusive co-lending agreements
Direct lenders have two choices 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 advisors, private equity firms and regional banks. However, challenged by the geographical scope of SMEs located across the continent, 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 that 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. 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.
Ensure relationships have broad geographic scope
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, which have already been refused by banks’ exclusive or favoured 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 – namely, Royal Bank of Scotland (RBS), Danske Bank, DZ Bank and KBC Bank. 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. However, it is vital to remain cognisant 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.
 “Fund houses pile into direct lending as banks retreat”, published by the Financial Times on 6 March 2018
 "LCD Global Review – US/Europe”, published by S&P Global Market Intelligence in April 2017