Assessing the credit risk of direct lending funds

Benoit Vasseur

Direct lending funds have become a key part of Europe’s financial ecosystem. A growing number of funds are raising debt directly or via securitisation of their shares. Assessing the credit risk of this debt requires a very specific approach.

Banks no longer dominate the European corporate lending landscape: the non-bank sector accounted for 45% of total euro area lending as of Q2 2019, up from 33% in Q1 2008. The emergence of private debt funds has helped fuel this disintermediation process. Funds provide tailor-made solutions to corporate borrowers unable to find appealing terms in traditional banking because of size, leverage constraints or special structuring needs. Direct lending funds typically focus on the under-serviced middle market space, connecting SMEs to institutional investors.

In Europe, fundraising for senior direct lending funds is now on a par with CLO issuance, which reached EUR 30bn in 2019. “Direct lending funds share similarities with leveraged loan CLOs, but beyond an exposure to a portfolio of corporate debt managed by an asset manager with a strong background in this area, the risk profiles of the investment options are very different,” cautioned Benoit Vasseur, pictured above, a director in the structured finance team of Scope Ratings and co-author of a report out today.

End-investors in direct lending funds are all exposed to the same portfolio risk, as opposed to CLO investors, who are exposed to different risk profiles via tranching. “Thanks to this alignment of interest with investors, direct lending fund managers have a lot of flexibility in building and replenishing their asset portfolios,” Vasseur continued.

Private debt lending involves different types of borrowers to traditional bank lending. “The rigid cost structures and mechanistic lending approaches of commercial banks cannot compete in this market,” said Sebastian Dietzsch, co-author of today’s report and also a director in Scope’s structured finance team. Direct lending targets are generally SMEs with stable cash-flows and proper business models.

“Private debt lenders initially tend to adopt a more relationship-based approach with a strong emphasis on the security package and assets of the borrower, their lending focuses more on ex-ante alignment of incentives rather than ex-post monitoring. This is reflected in discipline through shorter maturities and a different covenant package,” Dietzsch continued. More than 60% of European direct lending transactions are M&A-related.

Demand for private debt funds is strong as they offer higher yields compared to other European asset classes, especially with low interest rates persisting. Close financial sponsor involvement partially offsets the generally weaker credit profile of direct lending transactions.

Private debt lenders can impose higher spreads because of their tailor-made approach and the client segment they target. Besides higher funding costs faced by non-bank lenders compared to banks with cheap deposits, the costs of obtaining credit relevant information drive the generally higher spreads.

Traditionally, funds have issued shares with equity-type properties to raise the financing needed to grant loans to selected corporate borrowers. Recent regulations, however, have incentivised institutional market participants to invest in rated debt products.

“As a result, we see an increasing number of funds raising debt financing directly or indirectly via securitisation of their shares. Luxembourg-domiciled entities issue most of these debt instruments in Europe, as Luxembourg offers comprehensive and flexible frameworks for securitisation and fund activities,” said Vasseur.

The full report can be downloaded here.

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