Europe: new kid on the block
The emergence of Europe as a direct lending market is still relatively recent. [Direct lending involves lenders other than banks making loans to companies without intermediaries, such as an investment bank, a broker or a private equity firm.] The changing regulatory landscape in the post-financial crisis era has transformed lending markets. The new capital adequacy rules, amplified by the Capital Requirements IV directive under Basel III, have forced banks to reduce the risk, and therefore the size of their loan portfolios.
Before 2008, banks granted more than 80% of loans to large companies in Europe. Data from S&P LCD shows that the European loan market has grown aggressively, from €15 billion in 1998 to €165 billion in 2007; a year before the global financial crisis.
In its wake, small and medium enterprises (SMEs) had little access to capital. Their borrowing needs could not reach the scale required to profitably access the bond market. This has created a void in the alternative lending market, and investment firms have filled the void left by European banks for SME financing.
Direct loans now represent 10% of the European loan market. This rapid growth is, in large part, due to renewed interest in the asset class. Investors with long-term liabilities are attracted by an illiquidity premium of nearly 60 basis points, as well as a desire for strong returns with little correlation to quoted markets, capital preservation and risk protection. inflation.
The United States: size matters
On the other side of the Atlantic, the United States remains the world’s largest direct lending market. American banking disintermediation began in the early 1980s, spurred by regulatory and policy changes that favored a market-based funding model for businesses.
Therefore, the US market is deeper and more liquid than the European market. In 2015, bank loans accounted for only 24% of financing for non-financial companies in the United States, compared to more than 74% in Europe.
But does this increased size and depth always guarantee better investment opportunities?
Europe vs USA: compare the pair
We believe that to succeed in the European market, investors must recognize its distinct characteristics and adapt their strategies to mitigate specific risks and capitalize on opportunities.
Risk and return: US funds tend to offer higher returns than European funds. This is because they tend to leverage funds, which is unusual in Europe. Leveraged funds generally have a cost. Managers tend to charge higher management fees, due to the higher potential returns offered. To date, the majority of European investors have not been attracted by the leverage effect of funds.
However, at the level of lending transactions, Europe excels in measures of risk-adjusted returns. It generated 80 basis points of spread per unit of leverage in the second quarter of 2017, compared to 70 basis points in the United States. Although it is interesting to note that historically European and US loan yields have been very similar.
Creation: Direct lending in Europe is a relationship-driven market. Banks control the majority of lending, which can make it difficult for direct lenders to access high-quality loans. But thanks to strong origination networks – especially those featuring formal co-lending agreements with European banks – investors can still access high-quality loans on an exclusive basis. As such, Europe is a much more efficient, bank-driven lending market than the institution-controlled US. The US market is more than five times the size of the European market in terms of primary issue. And, while the US market offers investors more choice, its bank-led European counterpart continues to grow in size.
Lower volatility: There are no retail investors in Europe, which essentially reduces volatility and the risk of technical surges. At the same time, the presence of retail investors in the United States means that investors are likely to react quickly to market developments.
Exposure to oil and gas: European bank loans have limited exposure to oil and gas. But the US market, given its size, has a significant number of companies affected by the continued volatility in oil prices, which has led to higher default rates in recent years compared to Europe.
Equity Contribution: European loans are typically backed by more equity than those in the United States, providing better downside protection for bond investors. Over the past decade, S&P data suggests that European leveraged loans had a higher 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% in the United States. Additionally, corporate EV in the US is becoming increasingly expensive: the average purchase price – as a multiple of rolling EBITDA – reached 10.3x in the first half of 2017 compared to 9.6x in Europe.
Multiple leverage: Average loan leverage multiples, measured as total debt to EBITDA, increased in Europe and the US in the first six months of the year to 4.9x and 5.3x, respectively . This remains well below the maximum leverage levels of 6.0x in 2007.
Average loan life: In Europe, the average life of a loan is longer than in the United States, which generally refinances after two years. A loan with a longer life gives businesses more time to deleverage and ultimately improve their credit quality.
Initial costs: For European leveraged loans, upfront fees represent a significantly larger share of the overall return for managers, typically around 3%; this compares to about 50 basis points in the United States.
Documentation: Loan documents and reporting requirements are more standardized in the United States. In Europe, the documentation differs from country to country. Rather than being an inconvenience, this allows for more personalized documentation which benefits direct lenders with expertise in loan structuring. These tailor-made agreements offer the possibility of negotiating stricter clauses and thus ensuring better downside protection.
Legal framework: The United States is governed by one rule of law. Under Chapter 11 of the US Bankruptcy Code, creditors are entitled to protection for a certain period. A similar legal framework does not exist in Europe. Instead, there are inconsistencies in the region’s solvency regimes, with highly creditor-friendly jurisdictions in Northern Europe and less creditor-friendly jurisdictions in some countries, such as France and Italy, which can make loan restructuring more complex.
Recovery rate and restructuring times: The average recovery rate for UK loans is currently 89% and the average loan restructuring time is one year. In the most creditor-friendly countries in the region – including the UK, Ireland, Germany, Scandinavia and the Benelux countries – the recovery rate is 87.2% and the average restructuring period is 1.1 years. This compares favorably to the United States, where the average recovery rate is 77% and the time required for restructuring is 1.5 years.
The direct lending landscapes in Europe and the United States provide investors with different risk-reward settings. Yes, the United States is the most established territory, but the rapid growth of direct loans in Europe and the diversity of the market offer many advantages, including:
- Attractive upfront costs
- Less volatility
- High equity contributions
- Lower average leverage multiples
- Limited exposure to oil and gas markets
- Longer average loan life
- Higher recovery rates in Northern Europe
- We believe that a direct lending strategy focused on Northern Europe and led by a skilled team with strong origination capability can exploit opportunities that can match or exceed those found in the United States.
Follow us on twitter: @Hermèsinvest