Oct 10 (Reuters) - Growing pressure on lenders to reduce covenants in the syndicated loan market is filtering down to the middle market, prompting direct lenders to find a creative way to navigate an increasingly competitive industry.
A report from the Alternative Credit Council (ACC) and law firm Dechert published last week found that over the past three years almost half of all direct lenders have offered more attractive covenants and pricing as liquidity has increased.
The ACC report noted that the “trend towards less onerous covenants and less favourable loan pricing for the lender is more prevalent at the upper end of the market,” pushing managers of funds with more than a US$1bn in committed capital to find new ways to originate transactions.
STYLISTIC DIFFERENCES Larger debt funds are responding to the growing pressure with stylistic differences emerging among the well-known names. The top ten funds accounted for 67% of all non-bank activity this year, up from 60% in 2016, according to debt advisory firm AlixPartners.
Firms have expanded into new geographic territories such as Germany and Italy, where recent regulatory changes have made it friendlier to alternative lenders, and sponsorless deals have become an increasing focus for some.
Other lenders have developed close partnership with banks. Hermes Investment Management launched a £750m strategy last year and has partnered up with RBS to tap into the bank’s huge origination resources.
“It’s important to be a credit picker and working with banks means you can create enough opportunities,” said Patrick Marshall, head of private debt and CLOs at Hermes. Hermes also charges management fees based on the net asset value of the fund, rather than when capital is committed decreasing the pressure to deploy.
“If a loan underperforms, we’re penalised. It creates an alignment of interests with our investors, which means we won’t go higher than 5.5 times senior leverage,” Marshall said.
BlueBay Asset Management is looking towards the upper end of the middle market to source opportunities and raised over €3bn for a senior loan fund in July to complement its similarly-sized direct lending fund.
“The market has bifurcated,” said Anthony Fobel, managing partner of BlueBay’s private debt business.
“For deal sizes between €100m and €300m, competition is less intense with fewer firms able to underwrite and hold the whole loan. Below this range, it is a competition between a large number of smaller funds and the banks.”
PREMIUM SERVICE While there has been a general worsening of the terms across the industry, it has not been to the same level as the leveraged loan market.
For some sponsors the speed and ability of funds to underwrite a deal is an advantage even if they are more expensive than bank debt.
“We’re happy to pay a premium for the service if it means we can get the financing quickly,” said Frans Tieleman, managing partner at private equity firm Eurazeo.
A growing number of sponsors and intermediaries are taking an increasingly more process driven approach to deals, with many attempting to use the terms of one transaction as a template for the next.
Further, more creative use of Ebtida add-backs are being pushed by sponsors to obtain additional levels of financing.
But the lack of a secondary market for middle market loans, in contrast with leveraged loans, means the covenants are holding up. “There is competition in the market, but the loans are not tradeable in the way larger loans are, so there has to be more protection for lenders,” said David Miles, partner at law firm Dechert.
“Direct lenders will fight to retain the leverage covenant. That is the key one,” he said. (Editing by Christopher Mangham)