1. Direct Lending
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jASON CARLEY, CHIEF INVESTM E OFFI CER, BLIV PARTNERS
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N
otwithstanding the recovery of public
markets, the financing environment for Fig.l Annual private-sector loan growth to non-financial corporations (includes large corporates,
businesses in Europe continues to remain middle-market companies and SMEs) from December 2008-December 2009
difficult. In particular, the situation facing small
Source Source. Bank of England, European Central Bank and Fitch Ratings
and medium -sized enterprises, or SMEs, that form
the backbone of the European economy is very
o%
challenging. Over the past twelve months, most
were unable to access bank, bond or equity markets
for working capital or growth capital. The prolonged -2%
and severe contraction in lending to this sector is
becoming a major political and commercial risk. to
Europe given the sector's contribution to European
GOP. To a large extent this environment is caused by
structural changes in the debt markets for European
-6%
SMEs.
The credit expansion of 2004-2007 was marked by -8%
a significant increase in the ava ilability of capital
from a variety of lenders to large, medium and small
companies across the capital structure. These lenders -10%
were almost always leveraged and pricing was
based more on what the market would absorb than
on fundamental credit criteria. At the time, many
Germany UK Ireland Italy Belgiu m France Spain
hedge funds were active in the credit markets and
commercial and investment banks aggressively grew
their loan portfolios. After four years of accelerating
loan growth, the sy ndicated loan market collapsed In addition to bank lending , European companies distressed sector. In Europe, this frequently involves
in mid-2007 and the suppliers of debt capital that fed are struggling with a tough macro environment. privately-owned middle-market companies with a
the expand ing credit cycle retreated or completely For example, recent data shows that European good fundamental business model, but which are
abandoned the lending space. debt write-offs due to non-payments have reached frustrated by their inability to grow or defend their
a record level of €300 billion, a figure that is equal market position due to the absence of working or
As a result, commercial banks are now faced with to Greece's total national debt- and like Greece's growth credit.
tighter regulatory oversight and limited capacity debt, it too has not yet necessarily peaked. SMEs
for new loans and are focusing on their existing are hardest hit by the rise in non-payments. The Whereas this strategy is relatively well established
corporate and sovereign cred it exposure. Hedge fund European Commission claims that this is the cause of in the United States with many alternative asset
redemptions have forced funds that offered their one out offour corporate insolvencies leading to the managers active in the space (Blackstone/GSO, D. E.
investors short-term liquidity to side pocket assets loss of 450,000 jobs each year. Shaw, FrontPoint/ Gottex and Silver Point Capital), it
related to the less liquid loan portfolios, which often is largely unheard of in Europe. Historically this has
made up a significant portion of their books. In an Maturing mezzanine programs are also putting been to due to challenges associated with sourcing
attempt to restore the confidence of their investors, pressure on companies: 760 mezzanine financings and managing transactions without a strong and
these funds are now focusing on their respective core with an aggregate value of over €4 billion are trusted relationship network.
strategies and (quite rightly) are no longer active in coming due between 2011 and 2014 in Germany
the illiquid space. alone . At the same time, a number of traditional Direct financing providers aim to provide capital
mezzanine investors have withdrawn from the solutions that meet the unique requirements of
Cred it constraint has been a particular problem market over the past six months, in many cases due borrowers using debt or hybrid debt and equity
in Europe, with many countries experiencing an to excessive involvement in highly-impaired, and solutions . The willingness on the part of lenders
on-going decline in the volume of loans provided to poorly structured, LBO mezzanine debt. to share in some of the company's business risks
middle-market companies. creates more flexibility and options for companies in
In summary, with over €400 billion in European need of non-traditional financing. Traditional banks,
As an example, the situation in Germany reflects leveraged loans maturing before the end of 2014 on the other hand, are usually unwilling to work on
the general problems faced by SMEs across Europe and traditional lenders suffering from continuing innovative structures, particularly post-crisis. Often,
Compan ies have i ncreasi ng difficulty in getting capital constraints, there is no quick solution to the non-traditional lenders are also able to execute
loans because the lending criteria requirements of contraction in bank financing for small to medium- more quickly and reliably than traditional sources of
local German banks on equity capital, covenants, sized companies in Europe through traditional credit capital- a significant advantage in many situations.
transparency and documentation have grown far channels.
stricter over the last two years . KfW, a lead ing The underlying goal in any direct lending transaction
German government-owned development bank, Key aspects of direct lending is to see borrowers overcome their temporary
expects declines In lending to this space of The target market for a direct lending strategy challenges regarding a lack of capital, grow their
approximately 19% in each of the first two quarters is positioned between those companies with businesses and repay the financings in a timely
of 2010. financing (typically larger capitalisation) and the manner with a reasonable return for the lend er. Thi s
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2. is where direct lending differentiates itselffrom the current income, direct lending products can also
"loan-to-own" approach to debt investing typically distribute income on a regular basis making the
used to source private equ ity opportunities. opportunity very attractive to pension funds
and insurance companies that are interested in
The Willing ness nn
For family-owned SMEs, there is a deep fear of losing
control of the equ ity In a bus iness which almost
receiving a current yield on their investments in
addition to longer term capital gains. In addition
t l1e part of lendPi s to
always has emotional as well as financial links to
the owner. Th is means that sourcing transactions
to the institutional market, private investors with a
medium-term investment horizon also fit as natural
share in sorTie of the
i n that segment is virtually impossible without a
deep network of trusted existing relationships. Firms
investors in this strategy.
company's business
that are pe rceived not to share the same cultural
approach towards partnersh ips are mistrusted.
BLM's strategy
BLM pursues its direct lending efforts as a
risks c..reates n101-e
Direct financing investments are generally for
standalone strategy- it aims to lend and
recover capital, not trigger some form of debt/
flexi bllity and optic~ns
a term of two to three years and are secured by
strong collateral support in the form of physical
equity restructuring. The extensive network of
relationships with companies, entrepreneurs, senior
Fo1· companies in rv~ed
assets or cash flows. Since the capital infusions
are geared towards particular situations, such as
corporate management and financial institutions
that BLM's founding partners and professionals
of non-t1·adrtir!11al
growth strategies and acquisitions or working capital
shortages, direct lending investments usually do
have formed throughout Europe allows the firm to
source attractive primary investment opportunities.
Fnanrirlg.
not continue beyond the planned term. The target Potential borrowers take comfort from the history
annualised return is partly achieved via cash coupons that BLM's partners have of working closely with
and partly in the form of other contractual returns management teams to build successful companies,
(typically back-ended). For borrowers, this structure as well as their extens ive knowledge of European
also demonstrates a commitment to slrare in the corporate markets. The focus on relationships
risks of the1r business. Since the focus is on corporate with European borrowers is combined with a
loans rather than asset-backed securities, specific rigorous fundamental and structuring approach,
covenants and terms to each transaction are used combining the best of both US and European private
to mitigate risk and, together with cash interest investment approaches.
payments, to install cash flow discipline within the
borrowing company. BLM is positioned as a strategic partner and
compared to other firms, engages in a more
Risk in this investment strategy is primarily supportive approach with borrowers (as far as
managed via appropriate trade sizing and limiting possible). It seeks to bring financial, strategic and
concentrations and correlations among investments. operational support to middle-market companies
These are usually formulated as restrictions on in which it invests. Continual communication with
individual borrower positions, single sector exposure borrowers makes it easier to manage each position
and maximum geographic concentrations. in the portfolio and react to problems at an early
stage. Typically, BLM will have board rights to
Direct lending funds provide access, information and a regular forum
As one of the drivers of returns, direct lending to discuss a company's performance and future
temporarily gives up liquidity and commits capital strategy. Working with corporate borrowers rather
up to three years or beyond . The illiquidity of the than asset-backed securities also gives BLM more
underlying debt investments makes it important flexibility when it comes to managing problem
to structure funds with a matching liability profile. situations, more options for recovery and the
From an investor's perspective, this means that the opportunity to bring BLM's operational expertise to
time horizon lies somewhere in between trad it ional bear.
hedge fund investments that offer three month ABOUT THE AUTHOR
liquidity and priva t e equity investments, which often Conclusion
require limited partners to commit their money for Direct lend ing in Europe has been difficult to
jASOi~ CARLEY
more than 10 years. pursue as a strategy, even for those firms that
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are active in the US market. Borrowers here are
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Direct lending provides opportun ities for higher nervous about purely financial investors and a
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yields, better covenants and more security compared network of relat ionships is key to originating
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to syndicated credit In retu rn for lower liqui dity on attractive t ransactions. However, direct lending
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the underlyi ng investments. Given the investment now presents a real opportunity for European SMEs
Crrecc lending <::..::1 sma!l t•) medrum-:1Le1j Eurc,pE·a~-~
horizon, direct lend ing products typically appeal to to access much needed capital. With the structural
CC•Pip2n1es that are loo Lir-;g for grc1v,.'th or
investors with a med ium-term time horizon who impa irment in bank lending markets likely to
ca;>'tal
want to diversify their portfolio to include European continue for many years, European investors are
cred it exposure. Since the loan investments gene rate likely to see much more of this strategy. THFJ
1 •Pj hedgefund] 1r l.:il 61