Direct lending managers eye Europe for new opportunities

Money managers running direct lending strategies are turning their attention to Europe in an effort to capture new and developing opportunities.

Sources said there has been an explosion in recent years, not only in direct lending strategies, but in the number of players in the market — both on the money management side and on the institutional investor side. According to hires reported by Pensions & Investments, institutional investors have committed or invested around $2 billion of assets in direct-lending-focused strategies in the past six months.

Data from provider eVestment LLC's origination and financing universe show cumulative net inflows of $2.1 billion in 2015, following inflows of $672.4 million in 2014. This year through February, there were net outflows of $87.5 million.

Money managers have found enough interest to embark on multiple rounds of fundraising. And Schroders PLC this month acquired a 25% stake in Dutch direct lending firm NEOS Business Finance — an alternative debt financing platform for small and midsize enterprises in the Netherlands — to capitalize on the thirst from corporations for non-bank financing.

“Europe is still at a relatively early stage in its journey of structural change whereby less of the debt finance provided to midmarket companies comes from banks, and is increasingly provided by alternative lenders” said Anthony Fobel, a partner and head of private debt at BlueBay Asset Management LLP, in London. “However, this is set to grow quite dramatically over the next few years.” Mr. Fobel said there is about e50 billion ($57 billion) in assets under management in direct lending strategies in Europe — compared with “practically zero” in 2009-"10.

Sources put bank financing of the U.S. economy at around 20%, with the remainder coming from non-bank capital. That proportion is flipped in Europe, with about 80% coming from bank financing, and Mr. Fobel said midmarket companies in Europe are almost 100% financed by the banks.

In December, BlueBay announced it had completed the fundraising of its Direct Lending Fund II in less than one year, closing at e2 billion — its revised target. The investors were all institutional investors, with allocations from the U.K., U.S. and Asia.

“The opportunity had been U.S. — we now believe, over the next three years, the greater opportunity is in Europe,” said Declan Canavan, Europe, the Middle East and Africa head of alternatives at J.P. Morgan Asset Management in London.

The key is banking regulations in Europe, such as Basel III, which have been pushing banks to deleverage. “One opportunity we are looking at in detail is the leasing space — in Europe most leasing platforms are owned by banks,” Mr. Canavan said. While the sector is performing, there are questions over whether it is “performing enough (for banks) to offset the balance sheet exposure needed to run that business. As there becomes more pressure on banks' capacity to lend, it is interesting. And regulators are very, very happy and encouraging (of) more private capital participation in Europe.” He said there are opportunities in leasing across multiple sectors, from aircraft to office equipment.

A number of pension funds have added direct lending to their stable of investments. Last year, the Pension Protection Fund, London, which has about £23 billion ($32.7 billion) of assets, committed around £400 million to Pricoa Capital Group, Prudential Financial Inc.'s private fixed-income arm. The investment falls under the PPF's hybrid asset allocation.

Long-dated investments was key, said Alan Goodman, London-based senior portfolio manager at the PPF. “For all of the hybrid assets, the PPF is looking to offset our liability risk profile, resulting in less reliance on gilt and swap markets,” Mr. Goodman said. That means looking at long-term, stable cash flows from other investments.

The Environment Agency Pension Fund, Bristol, has a 5% allocation to illiquid credit, equating to about £135 million for the £2.7 billion pension fund. That allocation is “generally focused on direct lending as we feel it is the most attractive area in this space,” said Mark Mansley, chief investment officer at the pension fund. “We like the fact that the opportunities in large part exist because banks are withdrawing from the space, creating a real value driver.”

Mr. Mansley said the EAPF prefers strategies that focus on developing or expanding a business, rather than those based on buyouts and tax management. “The sort of investing we like is a really good fit with our principles of being a long-term real investor, and can really help business progress.” The concept of being a responsible investor is at an early stage in this area, but the EAPF has found that conflicts and challenges are limited, and a few managers are willing to work with the pension fund on this issue. However, executives are also cautious about costs in this area — “we are keen to ensure fees are reasonable and performance fees are kept under control — that is likely to be an increasingly important aspect going forward,” Mr. Mansley said. EAPF has so far committed about £40 million, with less than 50% of that investment filled. It expects to be about 80% invested in 18 months.

That said, there is concern among some consultants that the rapid growth in demand for these strategies might have eroded their value.

“We still see robust demand from pension clients for strategies where the prospective yields are attractive relative to prospective equity returns and are accretive vs. a plan's discount rate,” said Michael J. Forestner, partner at Mercer in Atlanta.

However, the growing interest in these strategies is also putting pressure on managers to find opportunities in an increasingly crowded — and indefinable — market.

“We have observed an explosion in the number of people looking at it, and the number of managers,” said Chris Redmond, London-based global head of credit at Willis Towers Watson PLC. “Now I would say we are into the hundreds. That huge ramp-up in providers of capital, and effectively the erosion of the barriers to entry that existed back in 2011, mean that the valuation story has largely gone.” Mr. Redmond said there were probably fewer than 10 credible providers in 2011.

Willis Towers Watson consultants had been keen advocates of direct lending, particularly given the opportunity in Europe. A number of clients allocated “quite heavily toward the European midmarket space,” Mr. Redmond said. But now the firm is “a bit lukewarm on it as an opportunity — we think it gives you a modest pickup to the liquid comparable, the larger investment-grade high-yield bond market, but that pickup is probably just about adequate to compensate you for the fact that it is an illiquid asset class.”

Crowding of the market in terms of players means the quality of a provider is even more important.

“We are seeing increased competition in Europe as new players come into the market,” said Terry Harris, head of portfolio management, global private finance, at Babson Capital Management LLC, Charlotte, N.C. “Direct lending really requires a significant investment in infrastructure to be successful. (Managers have) to directly originate these loans, and that requires a seasoned investment relationship.” Those managers tend to get the first call when it comes to opportunities.

Babson's global private finance assets total $3.6 billion. n