Incumbency, a laser focus on risk mitigation, and a unique approach to ESG are critical in this “winner-takes-all” environment.
The European private credit market has continued to evolve in three key ways that are increasingly driving competitive dynamics, and ultimately investor returns. This article was adapted from an interview with private credit portfolio manager, Mark Wilton, who recently appeared on Barings’ podcast, Streaming Income. The full episode can be found here.
1. Competition Has Intensified and Incumbent Lenders Have Considerable Advantages
While many asset managers are active lenders in the European private credit market today, the pandemic has had a distinct impact on the competitive landscape. Most notably, transaction activity has become more concentrated among fewer lenders. This was a trend already in place pre-pandemic, but it has only accelerated over the past year and a half, as evidenced by more off-market transactions, fewer large auction processes, and private-equity firms doing more real origination work.
Whereas in the past, private equity sponsors may have looked for bids from five to ten lenders for a specific financing, today that number may be only two or three. Increasingly, those lenders outside of the top three are finding themselves on the outside looking in. Additionally, unlike the U.S., where deals are often done as club transactions, in Europe it is more often the case that deals are made with a sole lender. So two or three lenders may be in the mix at the beginning, but very often, it’s only a sole lender that “wins” the transaction. In other words, European private credit has increasingly become a “winner-takes-all” market.
Unsurprisingly, more established direct lenders that have a strong reputation and long-term sponsor relationships have considerable advantages in this market. Scale is also important as it provides for more instances of being an incumbent lender, a position that often brings greater access to deal flow. For instance, if a sponsor-owned borrower needs additional financing—a common occurrence in the space—the incumbent lender is likely at a distinct advantage to win the business. Having prior knowledge of the company enables the incumbent to quickly and efficiently underwrite a new transaction, and given the comfort level that likely exists on both sides coming in, a deal can often be seamlessly executed completely off market.
Additionally, with secondary market transactions, incumbent lenders often have a significant advantage to those underwriting a company for the first time, as they have already been steeped in a borrower’s financials often for a period of years. With that information, an incumbent lender can make a more informed evaluation of the merits of additional transactions. This allows the lender to more accurately price and take risk—or to pass on the transaction if the terms and pricing appear unfavorable.
It may not be an overstatement to say that never before have scale, relationships and incumbency been more critical in accessing and evaluating deal flow than they are today.
Figure 1: Market Share is Increasingly Going Toward Top Tier Managers
Source: GCA Altium MidCapMonitor Q4 2020.
2. The Tide Has Gone Out on Excessive Risk-Taking
Another trend that has continued to evolve in the space is how investors are thinking about risk and return. With so much capital raised in private credit strategies in recent years, it’s no surprise that some market participants have focused first and foremost on achieving the highest possible returns—with, arguably—a less stringent focus on the risks at hand.
From excessive leverage to aggressive terms and structures, to lending to higher-risk sectors, it’s fair to say that froth had worked its way into the system in the time leading up to the pandemic.
Fast-forward to today and the consequences of excessive risk-taking are beginning to show themselves in a divergence of portfolio performance across the industry. Not surprisingly, lenders who were more heavily concentrated in industries like retail and restaurants that were disproportionately hurt by the economic slowdown have suffered as a result.
At Barings, we take a more conservative approach and focus on risk-adjusted returns. This means that we are typically focused on the senior part of the capital structure and shying away from deals with aggressive terms or pricing—even if it means missing out on certain transactions. From a sector perspective, we generally do not do deals with companies in “fad” sectors like restaurants and retail, and we avoid other cyclical sectors.
Perhaps counterintuitively, this conservative approach has often led to opportunities to win business, as private equity sponsors and borrowers also recognize that excessive leverage and other more aggressive terms may not work in favor of the borrower or lender over a longer time horizon. Lower leverage allows borrowers to retain more of their cashflows to invest in growth rather than paying it all out in interest, which strikes a chord with many growth-focused private equity sponsors.
3. ESG-Focused Lending is Becoming More Prominent
Investors are focused more on ESG by the day. But it’s not only investors—it’s also managers, sponsors and the borrowers themselves. As we have discussed before, private credit, for a number of reasons, requires an approach that is distinctly different from the way ESG analysis is applied with publicly listed equity and fixed-income investments. First, private credit is an illiquid asset class, with a typical life cycle of three to five years. In contrast to the broadly syndicated markets, there is little or no ability to trade in and out of loans or to sell out of a deal. Additionally, unlike equity investors, debtholders do not own shares of the company or sit on company boards. As a result, debtholders cannot directly influence company behavior or decision-making. These factors greatly increase the importance of conducting ESG due diligence up front and getting it right.
For this market, ESG-forward or sustainability-linked loans are an innovative approach that can positively incentivize middle-market companies to enhance their ESG practices. And we have witnessed, over the past year, a material acceleration in such transactions. In essence, lenders can customize loan agreements with specific ESG or sustainability provisions. If a company meets a certain number of these criteria, it can get a reduction in its borrowing costs. While sustainability-linked margin ratchets offer material incentives for borrowers to potentially lower their interest payments, the magnitude of that reduction—typically on the order of 5 to 10 basis points (bps)—does not have a significant impact on investors. That is an impact that ESG-minded investors are generally willing to accept, given that the feature clearly incentivizes the borrowers and private equity owners to improve the company’s behaviors to benefit the environment and the wider society.
Barings offered one of the industry’s first sustainability-linked loans in the summer of 2020 and has since executed on several more transactions of this type. We anticipate that ESG or sustainability-linked loans will increasing become the norm in the industry as the incentives and motivations for investors, managers, sponsors and borrowers increasingly align to address these important issues.
Like all asset classes, the European private credit market continues to change and evolve. Today, the growing importance of having scale and relationships, in addition to an increasing focus on risk-taking and ESG are driving the most change in competitive dynamics. At Barings, we see opportunity for our investors in each of these areas and continue to see a landscape where attractive risk-adjusted returns are achievable—if one takes the right approach.