European banks joining fray after years of reticence, and the market is getting crowded
Money managers are seeing a resurgence in European banks' appetite to provide loans in parts of the direct lending market, adding another layer of competition to an already crowded market.
Sources said they have seen some European investment and commercial banks' appetites to lend normalize, following years of reticence as they labored to comply with regulations designed to stabilize and derisk the banking system after the financial crisis.
While the trend varies by country and market segment, competition is particularly acute in the senior-secured part of the private debt market — an area in which sources said direct lending managers already faced hurdles because banks have advantages including existing relationships with borrowers. Sources also highlighted that direct lending is a highly competitive market just from the choice of strategies available from money managers. Data by Preqin Ltd. show that, at the start of April, there were 348 private debt strategies in the global market looking to raise $168 billion from investors. Direct lending strategies account for 170 of that total, targeting $74 billion in assets. On the banking side, the Association for Financial Markets in Europe's high-yield data report shows leveraged loan issuance totaled €195.3 billion ($233.9 billion) in 2017, up 37.9% year-over-year.
"The bank retrenchment which was evident several years ago has now slowed or stopped as bank balance sheets have been repaired," said Patrick Marshall, head of private debt and collateralized loan obligations at Hermes Investment Management in London. "In fact, some banks which had exited the leveraged loan market or had mothballed their leveraged loan functions are now actively re-entering the market and taking share."
The onset of rules after the global financial crisis, such as Basel III, saw banks pull back to their home countries.
"That trend is ongoing but certain in the U.K.," said James Pearce, head of direct lending at M&G Investments in London. "And pre-crunch, banks typically held large, single-name positions; where a small number lost money was because of a high concentration in single names. Fast-forward to today and I think we've seen bank market appetite has normalized. They are all looking to grow market share and position, but I wouldn't say their risk appetite has materially changed — it has normalized." After the crisis, he noted, banks had "overcorrected."
Since the financial crisis there has been "€600 billion ($739.2 billion) of shrinkage of European banks' balance sheets," covering lending to non-financial corporates, said Fabian Chrobog, managing partner at North Wall Capital LLP in London.
Banks had in recent years been concentrating on simpler, larger deals with key clients. But as the market normalizes, "banks are once again competing with direct lenders," Mr. Chrobog said.
A resurgence in bank lending was identified as the biggest challenge to the direct lending market over the coming years by 24% of 80 respondents to a recent survey of private debt and private equity investors in the U.K., Europe, North America, Africa, Asia and the Middle East by fund trust and corporate services provider Intertrust Group BV, Amsterdam.
"Our study shows that despite the rise of private debt funds, professional investors believe that traditional banks will continue to be a dominant force in lending," said Michael Johnson, St. Helier, Jersey-based director, head of funds-Channel Islands, at Intertrust.
But there are regional variations, said Mr. Johnson and other sources, with Germany still dominated by the banks, which are "in a strong position to re-enter the market," Mr. Johnson said; while the U.K. market has been disintermediated by the private debt managers. "In contrast, U.K. banks that have retreated from traditional branch networks are much less likely to be able to regain this role for themselves, and so will need to turn to partnerships with private debt managers," Mr. Johnson added.
The resurgence of banks' appetite in Europe has not gone unnoticed across the pond. Jim Neumann, partner at Sussex Partners U.K. Ltd. in New York, said both investment and commercial banks have switched on "some of their lending desire. Part of that is driven by net interest margins getting higher as rates get higher," and while it has been a "slow process ... I've seen deals done where investment banks are now stepping back in."
However, the funding gap that was left by banks' retrenchment led to a "structural change to the European midmarket," Hermes' Mr. Marshall added. He said there are now "two distinct competing product segments in the market, the larger being senior-secured loans," which is dominated by banks, and the smaller segment unitranche loans, where "fund lenders are prevalent" due to this part of the market being higher risk and too capital-intensive to attract banks.
"Consequently, the structure of the midmarket has now settled with banks being very active and competitive with strong lending appetites in the larger senior-secured segment where (direct lending) funds have been less effective in gaining a foothold due to less ability to differentiate themselves," Mr. Marshall said.
"The competitiveness of banks has strengthened significantly over the last three years as their balance sheets have improved and it is reasonable to assume that this newfound strength and competitiveness ... will remain a feature of the senior-secured loan market in the future," he added.
Hermes executives believe banks will remain dominant in the senior-secured loan market because of a number of advantages they have over direct lenders: geographically dispersed origination teams, existing and long-term relationships with borrowers, and track records.
And the implications of those changes are that "it will remain a challenge for fund lenders to access the senior-secured midmarket because of the structural advantages that banks have, combined with their increasing appetite to lend," Mr. Marshall said.
That challenge has been addressed by Hermes' private debt unit through a formal partnership with banks "to provide us with senior-secured loan origination across Europe, rather than competing with these banks," Mr. Marshall said.
For the middle market segment, M&G Investments works with The Royal Bank of Scotland PLC, which originates deals. "We are the same level of seniority in the structure and get paid the same," Mr. Pearce said.
Intertrust's Mr. Johnson said another trend in partnerships within the direct lending market is "how banks are increasingly promoting bridging finance to private debt managers to allow them to provide working capital to the funds."
This trend is interesting as they are enjoying the success of direct lending, albeit lending to the fund rather than "the street," Mr. Johnson added.
And for those direct lenders that do not wish to partner, there are still areas where they will be the preferred counterparty.
Banks "have become a bit more aggressive in terms of their leverage terms over the last years," said Kirsten Bode, co-head of Muzinich & Co.'s pan-European private debt fund, based in Zurich.
"But if they provide the working capital funding there is still an opportunity for direct lending funds to provide (other facilities) or being faster and more flexible," she added.
"There are still a huge number of situations that cannot be satisfied by the banks. The market just needs to be educated to some extent" on the options, she said.