By Patrick Marshall on Tuesday 12 September 2017
Direct lending is a promising market in Europe, but does it offer better opportunities than its more-established US counterpart? Patrick Marshall, Hea
d of Private Debt & CLOs at Hermes Investment Management, assess the differences between the two and presents his views on what it takes to invest successfully in European loans.
Europe: New kid on the bloc
Europe’s emergence as a direct lending market is still relatively recent. The changing regulatory landscape in the post-financial crisis era transformed loan markets. New capital adequacy rules, amplified by the Capital Requirements IV directive under Basel III, have forced banks to reduce risk and therefore the size of their loan books.
Prior to 2008, banks provided more than 80% of larger corporate loans in Europe. Data from S&P LCD shows the European loan market grew aggressively from €15bn in 1998 to €165bn in 2007, a year before the global financial crisis.
In its wake, small- and medium-sized (SME) businesses had little access to capital. Their borrowing needs could not reach the scale required to cost-efficiently access the bond market. This created a gap in the market for alternative lending, and investment firms have filled the void left by European banks to provide SME financing.
Direct lending now accounts for 10% of Europe’s loan market. This rapid growth is in no small part driven by a surge of interest in the asset class. Investors with long-term liabilities are attracted by an illiquidity premium of almost 60bps, as well as a desire for strong yields that are lowly correlated with listed markets, capital preservation and inflation protection.
The US: Size matters
Across the Atlantic, the US remains the world’s largest direct-lending market. US bank disintermediation began in the early 1980s, spurred by regulatory changes and policies that promoted a market-based financing model for businesses.
As a result, the US market is deeper and more liquid than the European market. As of 2015, bank loans accounted for just 24% of non-financial corporate funding in the US, compared to more than 74% in Europe.
But does this greater size and depth ensure consistently better investment opportunities?
Europe v US: Compare the pair
It is our view that, to be successful in the European market, investors must recognise its distinct characteristics and adapt their strategies in order to mitigate specific risks and capitalise on opportunities.
Risk and return: US funds tend to provide higher returns than European funds. That’s because they tend to use fund leverage, which is unusual in Europe. Levered funds generally come at a cost. Managers have a tendency to charge higher management fees, due to the higher potential returns on offer. To date, the majority of European investors have not been keen on fund leverage.
However, at loan transaction levels, Europe excels on measures of risk-adjusted returns. It generated 80bps of spread per unit of leverage in the second quarter of 2017, compared with 70bps in the US. Although it is worth noting that historically European and US loan yields have been very similar.
Origination: Direct lending in Europe is a bank relationship-driven market. Banks control the majority of loans, which can make it difficult for direct lenders to access high-quality loans. But through strong origination networks – particularly those featuring formal co-lending agreements with European banks – investors can consistently access high-quality loans on an exclusive basis. As such, Europe is a much more efficient bank-led market for loans compared to the US, which is controlled by institutions. The US market is more than five times the size of the European market in terms of primary issuance (see Figure 1). And although the US market gives investors more depth of choice, its bank-led European peer is still growing in size.
Figure 1. Institutional loan volumes in the US and Europe
Lower volatility: There are no retail investors in Europe, which in essence reduces volatility and the risk of technically-driven surges. Meanwhile, the presence of retail investors in the US means investors are likely to react to market developments quickly.
Oil and gas exposure: European bank loans have limited exposure to oil and gas. But the US market, given its scale, has a substantial number of companies affected by the ongoing volatility of oil prices, which has resulted in higher default rates in recent years compared to Europe.
Equity contribution: European loans are typically backed by more equity than those in the US, providing greater downside protection for debt investors. Over the past decade, data from S&P suggests that European leveraged loans had a greater percentage of average contributed equity. In the first half of 2017, equity as a percentage of total sources stood at 46% in Europe, compared to 40% for the US. Furthermore, the EV of companies in the US are getting more expensive: the average purchase price, as a multiple of trailing EBITDA, reached 10.3x in the first half of 2017 compared to 9.6x in Europe.
Leverage multiples: Average leverage multiples on loans, measured as total debt to EBITDA, have climbed in both Europe and the US in the first six months of the year at 4.9x and 5.3x, respectively. This remains well below the peak leverage levels of 6.0x in 2007.
Average loan life: In Europe, the average life of a loan is longer than the US, which typically refinances after two years. A loan with a longer life provides companies with more time to deleverage and ultimately improve their credit quality.
Upfront fees: For European leveraged loans, upfront fees make up a substantially greater portion of overall yield for managers, usually around 3%. This compares to about 50bps in the US.
Documentation: Loan documentations and reporting requirements are more standardised in the US. In Europe, documentation differs on a country-by-country basis. Rather than being a drawback, this allows for more bespoke documentation that benefits direct lenders with expertise in loan structuring. These tailored agreements provide opportunities to negotiate stronger covenants and thereby secure greater downside protection.
Legal framework: The US is governed by a single rule of law. Under Chapter 11 of the US bankruptcy code, creditors are entitled to protection for a certain period of time. A similar legal framework does not exist in Europe. Instead, there are inconsistencies in solvency regimes across the region, with very creditor-friendly jurisdictions in Northern Europe and less creditor-friendly jurisdictions in certain countries such as France and Italy, which can make loan restructuring more complex.
Recovery rates and restructuring timeframes: The average recovery rate for UK loans currently stands at 89%, and the average time taken to restructure a loan is one year. Across the more creditor-friendly countries in the region – including the UK, Ireland, Germany, Scandinavia and the Benelux nations – the recovery rate is 87.2% and the average restructuring period is 1.1 years. This compares favourably with the US, where the average recovery rate is 77% and time taken to restructure is 1.5 years.
The direct lending landscapes of Europe and the US offer investors different risk-reward parameters. Yes, the US is the more established territory, but the rapid growth of direct lending in Europe and diversity within the market offer many benefits, which include: