Investors are embracing senior debt as a supposedly non-risk debt exposure, but as competition grows, can lenders hold their discipline?
"I certainly think the senior side is what’s popular these days," says Jeffrey Griffiths, principal in the London office of Campbell Lutyens, the private equity advisory firm and placement agent – encapsulating the sentiment of many market watchers.
He gives two reasons. One is dealflow. "That’s where most of the volume and supply is," says Griffiths. "Perhaps 60 percent of the financing is senior debt on both sides of the Atlantic, so just in terms of sheer volume there’s more opportunity on the senior than junior side."
Another is underlying investor appetite. "There’s still a bit of an aversion towards subordinated and other risky types of lending following the experience of the global financial crisis, because of the high losses in such lending during this time."
Griffiths even goes so far as to describe this as largely structural, saying: "There is somewhat more of a conservative paradigm in terms both of fund managers underwriting investments and of the appetite of limited partners."
Regulators on both sides of the Atlantic are encouraging this conservatism – US watchdogs have discouraged banks from lending at leverage ratios above six times EBITDA, also influencing leverage ratios offered by private debt funds. However, Griffiths believes lenders are also better at self-discipline when compared with the more freewheeling days before the credit crunch.
But while limited partners like the safety of senior debt and acknowledge the investment opportunities, they wish returns could be higher. "Although there is more scope to invest in senior loans than there used to be – particularly in Europe – the yields are still pretty tight," says Jonathan Bell, chief investment officer at Stanhope Capital, the wealth manager, in London.
In spread terms, yields have, in fact, become even lower in recent months. Alex Neiss, a member of the corporate and acquisition finance team at Investec in London, estimates that in Europe, loans that would have been made at 375 basis points above Euribor have fallen to about 325 basis points in the past six months.
"This is because there’s a lot of dry powder chasing such a small amount of paper," he says. US observers see a similar fall across the Atlantic. Fund managers might realistically have hoped for 10 percent all-in gross returns for "a conservatively structured, private senior loan to a lower mid-market company" three to five years ago, including any original issue discount, upfront fees and commissions, coupons and capital repayment, says Griffiths. Nowadays, he thinks they might still get 10 percent, but that is at the top end of the range.
Another market watcher posits a figure of 7 or 8 percent. Whatever the actual figure, the trend is down, and lenders must react. As Neiss puts it: "The risk-return on debt is getting pretty skinny, so people are looking to be creative."
This creativity takes many forms. Perhaps the most common attempt at a solution is to branch out from pure senior debt. "Many fund managers are willing to take a little more risk by stepping up to a higher-octane senior lending strategy," says Jeff Davis, partner at placement agent Eaton Partners in Rowayton, Connecticut.
"Those private lenders willing to do a little more unitranche or second lien are getting a lot of attention." Some senior debt specialists have also moved into subordinated debt as well, or into hybrid instruments – often mixing it all up in funds badged as "opportunistic credit".
These moves have allowed many funds to keep up their planned rates of return. For example, Stanhope has invested in Alcentra’s unitranche-focused European direct lending fund, "which will be able to give you that 10 percent", according to Naveed Chaudhry, partner and head of alternatives and fixed income at Stanhope.
Another solution is to broaden origination. This allows fund managers to improve the returns for senior debt by foregoing those deals where a financial sponsor will play a large number of would-be lenders off against each other as they compete to offer the cheapest deal, the highest leverage, the loosest covenant terms, or a combination of all three.
For lenders pursuing this option, "the non-sponsor deal is very interesting and a differentiator", says Davis. Lenders that have devoted resources to expanding geographically within Europe, beyond those sponsored deals arranged in the London market, have been able to improve their origination, according to market watchers. They refer to Ares, which has five European offices, and Hayfin, which has seven if Israel is included.
Floris Hovingh, partner and head of financial services firm Deloitte’s alternative capital solutions team in London, says a lender with good origination "might see 250 opportunities – and out of those opportunities they can choose the best eight to 10 deals". A lender without "boots on the ground" outside London might see only 150 opportunities.
Romain Cattet, partner at Marlborough Partners, the debt fund advisory firm, in London, echoes this: "If you want to build your fund size" – as many senior lenders are doing – "to invest your money you have to go as wide as possible". For this reason, "I think the market is going pan-European."
But at the same time, there’s a reason for some national markets not being well trodden. "The UK is easy and the rest of north-western Europe is fairly easy, but the bar for credit is higher in Spain and Italy, although an increasing number of lenders will look at this," says Hovingh. "Greece, Turkey and Cyprus are nearly impossible," he adds, citing political risk and other issues.
WATCH OUT FOR THE BULL
However, spreading the net geographically should help senior lenders avoid the customary hazard of a credit bull market – a hazard most European private debt funds are encountering for the first time. This is the risk that, with defaults still low and competition for the available pool of borrowers high, lenders will drop their guard and start lending foolishly.
Some observers worry that this is happening already. "A certain proportion of direct lenders are not as stringent as they should be," says one fund manager based in London. "They are certainly relaxing terms and due diligence requirements, and pushing up leverage levels, beyond what I would be comfortable with."
It may be the LPs that ultimately take any heat out of the market, by reducing the build-up of dry powder putting GPs under such pressure to lend. "We are seeing looser documentation and higher leverage," says a placement agent based in New York. "When there is a headwind, will these companies be in a position to perform or not? This puts investors in a more precarious situation."
He thinks that LPs are starting to question whether they want to invest in this environment – and any ensuing reluctance could, for the sake of the long-term sustainability of the market, be a positive outcome.https://www.privatedebtinvestor.com/news/global/2017-09-28/strategies-examined_-senior-debt/