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Hf journal june 2010 - direct lending a new asset class


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Hf journal june 2010 - direct lending a new asset class

  1. 1. Direct Lending A nr.w asser clcbJ n t.u r 1p~? 1 jASON CARLEY, CHIEF INVESTM E OFFI CER, BLIV PARTNERS NTN 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 2009difficult. In particular, the situation facing small Source Source. Bank of England, European Central Bank and Fitch Ratingsand medium -sized enterprises, or SMEs, that formthe backbone of the European economy is very o%challenging. Over the past twelve months, mostwere unable to access bank, bond or equity marketsfor working capital or growth capital. The prolonged -2%and severe contraction in lending to this sector isbecoming a major political and commercial risk. toEurope given the sectors contribution to EuropeanGOP. To a large extent this environment is caused bystructural 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 capitalfrom a variety of lenders to large, medium and smallcompanies across the capital structure. These lenders -10%were almost always leveraged and pricing wasbased more on what the market would absorb thanon fundamental credit criteria. At the time, many Germany UK Ireland Italy Belgiu m France Spainhedge funds were active in the credit markets andcommercial and investment banks aggressively grewtheir loan portfolios. After four years of acceleratingloan growth, the sy ndicated loan market collapsed In addition to bank lending , European companies distressed sector. In Europe, this frequently involvesin mid-2007 and the suppliers of debt capital that fed are struggling with a tough macro environment. privately-owned middle-market companies with athe expand ing credit cycle retreated or completely For example, recent data shows that European good fundamental business model, but which areabandoned 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 orAs a result, commercial banks are now faced with to Greeces total national debt- and like Greeces growth credit.tighter regulatory oversight and limited capacity debt, it too has not yet necessarily peaked. SMEsfor new loans and are focusing on their existing are hardest hit by the rise in non-payments. The Whereas this strategy is relatively well establishedcorporate and sovereign cred it exposure. Hedge fund European Commission claims that this is the cause of in the United States with many alternative assetredemptions 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), itrelated to the less liquid loan portfolios, which often is largely unheard of in Europe. Historically this hasmade up a significant portion of their books. In an Maturing mezzanine programs are also putting been to due to challenges associated with sourcingattempt to restore the confidence of their investors, pressure on companies: 760 mezzanine financings and managing transactions without a strong andthese 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 Germanythe 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 ofCred it constraint has been a particular problem market over the past six months, in many cases due borrowers using debt or hybrid debt and equityin Europe, with many countries experiencing an to excessive involvement in highly-impaired, and solutions . The willingness on the part of lenderson-going decline in the volume of loans provided to poorly structured, LBO mezzanine debt. to share in some of the companys business risksmiddle-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 onthe 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 executeloans because the lending criteria requirements of contraction in bank financing for small to medium- more quickly and reliably than traditional sources oflocal 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 transactionGerman government-owned development bank, Key aspects of direct lending is to see borrowers overcome their temporaryexpects declines In lending to this space of The target market for a direct lending strategy challenges regarding a lack of capital, grow theirapproximately 19% in each of the first two quarters is positioned between those companies with businesses and repay the financings in a timelyof 2010. financing (typically larger capitalisation) and the manner with a reasonable return for the lend er. Thi s60 thej hedgefund joumal
  2. 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 theused to source private equ ity opportunities. opportunity very attractive to pension funds and insurance companies that are interested in The Willing ness nnFor family-owned SMEs, there is a deep fear of losingcontrol 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 toalways has emotional as well as financial links tothe 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 thei n that segment is virtually impossible without adeep network of trusted existing relationships. Firms investors in this strategy. companys businessthat are pe rceived not to share the same culturalapproach towards partnersh ips are mistrusted. BLMs strategy BLM pursues its direct lending efforts as a risks c..reates n101-eDirect financing investments are generally for standalone strategy- it aims to lend and recover capital, not trigger some form of debt/ flexi bllity and optic~nsa term of two to three years and are secured bystrong collateral support in the form of physical equity restructuring. The extensive network of relationships with companies, entrepreneurs, senior Fo1· companies in rv~edassets or cash flows. Since the capital infusionsare geared towards particular situations, such as corporate management and financial institutions that BLMs founding partners and professionals of non-t1·adrtir!11algrowth strategies and acquisitions or working capitalshortages, 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 historyannualised return is partly achieved via cash coupons that BLMs partners have of working closely withand 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 Europeanalso demonstrates a commitment to slrare in the corporate markets. The focus on relationshipsrisks of the1r business. Since the focus is on corporate with European borrowers is combined with aloans 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 privateto mitigate risk and, together with cash interest investment approaches.payments, to install cash flow discipline within theborrowing company. BLM is positioned as a strategic partner and compared to other firms, engages in a moreRisk in this investment strategy is primarily supportive approach with borrowers (as far asmanaged via appropriate trade sizing and limiting possible). It seeks to bring financial, strategic andconcentrations and correlations among investments. operational support to middle-market companiesThese are usually formulated as restrictions on in which it invests. Continual communication withindividual borrower positions, single sector exposure borrowers makes it easier to manage each positionand maximum geographic concentrations. in the portfolio and react to problems at an early stage. Typically, BLM will have board rights toDirect lending funds provide access, information and a regular forumAs one of the drivers of returns, direct lending to discuss a companys performance and futuretemporarily gives up liquidity and commits capital strategy. Working with corporate borrowers ratherup to three years or beyond . The illiquidity of the than asset-backed securities also gives BLM moreunderlying debt investments makes it important flexibility when it comes to managing problemto structure funds with a matching liability profile. situations, more options for recovery and theFrom an investors perspective, this means that the opportunity to bring BLMs operational expertise totime horizon lies somewhere in between trad it ional bear.hedge fund investments that offer three month ABOUT THE AUTHORliquidity and priva t e equity investments, which often Conclusionrequire limited partners to commit their money for Direct lend ing in Europe has been difficult to jASOi~ CARLEYmore than 10 years. pursue as a strategy, even for those firms that jas,Yl L21l1~_v ;s ~~hier•ert Uflrc:c-r .:.n· f,Lh,.l are active in the US market. Borrowers here are ar: :nde~~erldemallernat:rve irwestmer-ltDirect lending provides opportun ities for higher nervous about purely financial investors and a flr-r11 ser·vrr1g sr-,..dll ard nledrurn-srzeo CtXInanies rnyields, better covenants and more security compared network of relat ionships is key to originating Eur-ope· auc:ss vcrrroL:~- 1ndus:rres thmugh a r·ar·~~ltto syndicated credit In retu rn for lower liqui dity on attractive t ransactions. However, direct lending cf inves1.m2r1t srrctcgic:.. A marr1 tocus ~or ELiv·i iS:.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 orinvestors with a med ium-term time horizon who impa irment in bank lending markets likely to ca;>talwant to diversify their portfolio to include European continue for many years, European investors arecred it exposure. Since the loan investments gene rate likely to see much more of this strategy. THFJ 1 •Pj hedgefund] 1r l.:il 61