Treasury Today Country Profiles in association with Citi

Direct lending putting mid-market borrowers back in the game

Person lending someone money

With constraints on bank lending hitting many mid-market corporates, one alternative source of funding is direct lending. Can it really plug the gap?

As banks come under increasing regulatory pressure, particularly from Basel III, they have become more careful about lending limits. With the Bank of International Settlements reporting that to mid-2015 cross-border lending had fallen by $910bn, the largest slump since the fourth quarter of 2008, the figures do not look good for businesses not in favour with their banks.

Ally this with the retrenchment of some major international banks to their home territories, and it is easy to see why a lending gap has been created in the €100m to €1bn turnover mid-market sector. Too big for crowd-funding or VC money, a serious funding shortfall will damage development in the sector that is widely seen as the engine of growth for just about every developed economy in the world.

But the gap is now being filled in part by private funding as more mid-market corporates look to raise long-term capital through institutional investors such as the insurance companies and pension funds.

These investors have in recent years increasingly opted for direct lending to large corporates via the private placement market as a fixed income alternative. Deals have tended to be for $200m or more. For companies seeking refinancing or growth capital sums of between €40 and €150m – notably those in the 25,000-strong European mid-market sector – the willingness of institutional funds, keen to eke out returns on their capital by accessing mid-market borrowers through direct lending, is a lifeline.

Bank supporting role

This is not an attempt to cut the banks out of the deal, explains Mike Anderson, Head of Investor Relations at asset management firm, Pemberton (which is backed by Legal & General, the UK’s largest insurance company). “Banks will continue to play a role in supporting European mid-market companies in partnership with private debt funds,” he says.

“The approach we take is to work with the banks and their corporate clients because we recognise that the banks have constraints on the amounts they can lend and so they are looking for institutional partners to support the financing needs of their clients.

“Direct lending is allowing the banks to have more regular discussions with corporates about their financing needs and maybe helping to put more loans in place rather than saying they cannot help.” In most cases, the company seeking funding will contact its bank first. Where the bank is not able to support its client it may contact an intermediary such as Pemberton but still provide the hedging, swaps and day-to-day banking that sits astride the longer-term funding provided by the institutional investor.

Credit risk approach

Typically, because of their size, mid-market borrowers seeking direct lending are almost by definition sub-investment grade, says Anderson. Today, no bank would lend to an unrated part of the market without fully understanding the credit risk. The direct lending space takes the same approach.

Every company seeking investment through Pemberton, for example, will be credit-assessed and unofficially rated. “There is enough information on these companies to be able to use sophisticated software to create very accurate proxies of public ratings,” Anderson explains. The rating is not fixed and will be positively affected by factors such as increased profits, margins and scale of the business.

Institutional investors in this space are looking at companies with equivalent ratings of BB- to B. Borrowers at this level wanting five or seven-year money will pay around LIBOR +500/550 plus an arrangement fee. A firm rated BB that has access to the private placement market might secure LIBOR +400. “It all comes down to the risk profile of each company and how that risk translates into the margin they have to pay,” comments Anderson.

A growth market

There is a desire to create a new channel to deploy longer-dated institutional money in the form of direct lending. Deloitte’s most recent Alternative Lender Deal Tracker shows that whilst the US high-yield bond/leveraged loan markets are suffering, in UK and Europe institutional investors are becoming more comfortable with the idea of non-bank, direct lending. In Q1 2015, private sponsorless deals in the region accounted for 21% of total deals. By Q3, they accounted for 25%. Current outstanding debt in this sector is around €2trn.

Despite the apparent growth, direct lending in Europe is still in its infancy. In the US, where major consolidation of the banking sector had already taken place some years ago, Anderson notes that banks lost a lot of ground to non-bank lenders such as the insurers and pension and mutual funds. The US private placement market is stronger than in any other market.

The US saw 80% of funding provided by non-bank lenders in 2014. In comparison, Europe’s banks have remained the lenders of choice, with only 7% of funding provided by non-bank lenders in 2014. “I don’t think we will get to the US position,” acknowledges Anderson. “Our view is that the banks will continue to dominate the market but direct lenders will increasingly pick up market share, predominantly through a partnership approach with the banks.” For mid-market corporate treasurers, another source of funding must surely be welcome.