A new report, Financing the Economy 2016, looks at “the role of alternative asset managers in the non-bank lending environment,” addressing such questions as the likely impact of an exit of the United Kingdom from the European Union (a “Brexit,”) upon Europe-focused direct lending vehicles.
The paper is a joint production of the AIMA Alternative Credit Council and Deloitte LLP, and is based on a survey of lenders, with collective AUM of $670 billion, and with a little more than one-quarter of that total allocated to private credit strategies.
In general, as the Foreword says, “many investors now view direct lending as an important part of their investment strategy.” It has become both a generator of stable returns and an element of diversification, and so is here to stay.
Since banks are risk averse creatures, and Brexit enhances risk, one can reasonably expect that the sloppy process underway will “create opportunities for alternative lenders who have locked in capital to target those companies neglected by banks,” and accelerate the growth of this space.
Lenders, Investors, Borrowers
Getting past the forward and into the report proper … a reader learns that alternative lenders come from four distinct backgrounds: there are those who have “always [been] doing what they are doing now,” there are those who have come into the direct lending space from the private equity world, there are hedge funds, and finally there are traditional long-only asset managers.
Who invests in such lenders? The short answer: mostly institutions. They’re looking for long-term secure investments, and they’re willing to tolerate illiquidity given their own time horizons.
So … who are the borrowers? The majority come from mid-market businesses who want money for growth or refinancing. Chiefly they have EBITDA above $10 million. More than 50% of the borrowers are in the $25 million to $75 million category by EBITDA.
This means that the size of the average borrower has grown since the last survey was done, a year before. “This is perhaps,” the authors suggest, “a reflection of the growing maturity of the market and the more discriminatory nature than alternative lenders are showing in their credit selectin process.” As an example, they refer to a U.K. packaging company, Petainer, which “provides sustainable packaging for consumer goods such as alcoholic beverages, soft drinks, water and sauces.” Petainer has received a ?100 million ($130 million) loan from KKR which will be used both to restructure the company’s finances and to grow.
Survey respondents identified five distinct advantages of non-bank (and non-bond) financing: flexibility of terms; ability to carry out complicated deal structures; speed combined with rigor and the ability to lend in size; long term relationships; low leverage levels from the lenders themselves.
In connection with the long term nature of such relationships, the report observes that alt lenders often employ a structure with a six to eight year fund life cycle. There is an investment period of two to four years, then a harvesting period for the remaining of the cycle. “Duration of loans” the authors observe, “is therefore set to match this type of fund structure, with the majority of loans falling into the two to six year maturity.” The length of the cycle employed has been growing over time, and alt lenders in many instances now structure the loan “as a bullet payment that does not amortize over the course of the financing.”
The issue of the leverage levels of the non-bank lenders is of course of significance to their investors. Banks operate at leverage levels from 10 to 20 times their equity. That is one of the factors that can make institutional investors wary of too much exposure to that sector.
Going more granular, the report in a footnote gives data from Bloomberg on the four largest U.S. banks and their leverage: JP Morgan 11.37; Bank of America 9.28; Wells Fargo 10.35; Citigroup 8.83. The largest European banks? HSBC 13.31; BHP Paribas 23.77; Credit Agricole 32.42; Deutsche Bank 25.47.
An ESMA Opinion
Survey participants have been alarmed by a newly issued opinion of the European Securities Markets Authority (ESMA) regarding loan origination funds. ESMA doesn’t rule out the possibility of another layer of regulation in addition to the strict requirements that already exist on this industry via the AIFMD.
For example, ESMA and it seems some ERU members states believe there is a need for new leverage restrictions, despite the above discussed distinction between such funds and traditional banks, in favor of the former as to leverage.
Alternative lenders must continue to give expensive employment to lawyers in order to keep track of the shifting regulations in the field, and that in turn may hamper the growth of the market.
The report concludes that it “will be interesting to see if and when the industry can enter its next phase and compete with public markets.”