Direct Lending in the EU: New Regulations on Loan Origination Create High-Return Opportunities for Asset Managers

In the post-crisis landscape, stringent regulations and stricter capital requirements led banks to reduce their lending volumes. As a result, the “originate to distribute” model of corporate financing is declining, even in Europe where intermediated finance is still prevalent.^[1] Non-bank institutions such as investment funds and insurance companies are increasingly taking advantage of regulatory changes regarding direct lending across European jurisdictions, and EU direct lending is catching up to the U.S. market.

Midmarket deals are booming across Europe. Deloitte recorded an impressive 15% increase in alternative lending deals in 2017. In Q3 2017 alone, approximately 82 funds targeted commitments amounting to $41 billion. The U.K. (120 deals from Q3 2016 to Q3 2017) and France (70 deals from Q3 2016 to Q3 2017) are the leading markets in Europe.

Institutional investors such as Allianz, AIMCO, Standard Life and M&G have recently entered the origination business, which was originally captured by a few experienced asset managers. In France, managers such as Idinvest and Tikehau are consolidating their positions as major players.

An attractive opportunity for both LPs and borrowers

Direct lending offers borrowers flexibility (covenant-lite structures, cash sweeps, CAPEX facilities which are crucial for LBOs, etc.) and speed of execution (thanks to the simplified decision-making processes of alternative lenders compared to traditional banks) with little to no equity dilution. They are mostly used in LBOs, bolt-on acquisitions and growth capital for SMEs that are struggling to obtain traditional bank loans and can’t tap public markets. Some large-cap corporations are also choosing direct lending over syndicated bank loans for the speed of execution and flexibility it offers.

On the supply side, direct lenders are able to attract return-hungry LPs with IRR between 5% and 10% thanks to the 600-1500bps margins on the loans they originate (i.e., at least 200 bps over benchmark syndicated loan rates). The most common LPs are institutional investors such as insurance or pension funds, banks, and private wealth funds. Sovereign funds (European Investment Fund, European Investment Bank, Bpifrance, etc.) are increasingly investing in debt funds as a part of the EU’s policy for SME financing.

New regulations on loan origination

Over the past few years, many EU jurisdictions have implemented new regulations in order to allow alternative lenders to originate loans directly to nonfinancial companies.

A new regulation applicable across all EU Member States since Dec. 2015^[2] introduced the European Long-Term Investment Fund (ELTIF), a pan-European label granted to alternative investment funds (AIFs) by national market authorities, which allows them to originate loans in all EU jurisdictions if they meet certain conditions (such as assets eligibility criteria, diversification rules, limitations on leverage and derivatives, etc.).

Likewise, France is opening up its “banking monopoly,” a cornerstone regulation that used to exclude non-banks from direct lending. Since 2016, securitization vehicles^[3] and some AIFs (namely, specialized investment funds^[4] and PE funds^[5]) are allowed to originate loans, either under the ELTIF label or under the specific conditions set out in a Decree.^[6] More recently, French regulators pushed further for the development of direct lending with a Decree^[7] introducing a new category of French AIFs called specialized financing vehicles (SFVs)^[8] that are well-suited for direct lending thanks to the great flexibility they offer to asset managers and thanks to their preferential regulatory treatment. (SFVs will, for example, be allowed to issue bonds, benefit from simple receivable transfer mechanisms and be shielded from insolvency proceedings.)

Italy^[9] and Germany^[10] have implemented similar regulations, while some other EU jurisdictions such as the U.K., Luxembourg, Ireland and the Netherlands also allow direct lending through funds.

What asset managers need to know

• First lien structures (either senior secured or plain-vanilla unitranche) are the most popular with direct lending, representing 85% of transactions in 2017. Alternative lenders also originate Euro Private Placements (Euro PP), through loans or bond structures (mostly senior unsecured), which are popular with French insurers and pension funds. Loans originated by alternative lenders are usually non-amortizing with a maturity between three to eight years.
• Cross-border deals are fairly common. Most funds are opting for either a global or pan-European strategy in order to improve portfolio diversification.
• Some direct lenders are teaming up to access larger deals.
• Management fees usually amount to approximately 1% and are sometimes coupled with a performance fee.
• Most funds have a 10-year maturity with an investment period of three to five years. While buy-and-hold strategies are the norm for direct lending, most EU jurisdictions do not strictly prevent asset managers from transferring loans they originated before the loans' maturity date. Some funds have included these arbitrage opportunities in their management strategy in order to improve their risk management and increase their returns.
• In a post-Brexit environment, U.K.-based assets managers will likely have to relocate within the EU27 to access the European direct lending market. Paris, Frankfurt and Dublin have emerged as the main destinations in this regard.

Conclusion

Direct lending constitutes a unique opportunity for asset managers, both in a short-term perspective (attractive risk/return profiles in a low-yield environment) and a long-term perspective (disintermediation of European finance coupled with the anticipated post-Brexit changes).

To benefit from those opportunities, asset managers should seek to develop their credit expertise and closely monitor new regulations, since being up to date on those regulatory changes (e.g., the new SFV regime in France) may constitute a key advantage in a very competitive market.

^[1] Banks account for 80% of long-term corporate lending in Europe, compared with 20% in the U.S.

^[2] Regulation (EU) 2015/760 of the European Parliament and of the Council of April 29, 2015

^[3] “organismes de titrisation”

^[4] “fonds professionnels spécialisés”

^[5] “fonds professionnels de capital investissement”

^[6] Decree No. 2016-1587 dated Nov. 24, 2016

^[7] Decree No. 2017-1432 dated Oct. 4, 2017

^[8] “organismes de financement spécialisé”

^[9] Law Decree No. 18/2016 dated February 14, 2014

^[10] “UCITS V Implementation Act” dated February 5, 2016