Parallel lending: The next frontier for private credit

December 4, 2024

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Lending partnerships between asset managers and European banks may lead to low-risk, highly diversified private debt portfolios and potentially attractive returns for investors, argue Gianluca Oricchio and Gianpaolo Pellegrini.

Ongoing bank disintermediation since the Global Financial Crisis is a well-known cause and driver of European direct lending.¹ Over the last 15 years, many asset managers have successfully launched alternative lending strategies, often acting as sole lender to provide companies with tailor-made financing structures (unitranche, mezzanine, junior debt) when bank finance is too difficult or too costly to access. Today, the alternative lending market is huge, with non-bank financing accounting for nearly 50% of global financial assets.²

A mutually beneficial partnership

As the market grows and evolves, a new sub-asset class has emerged, born out of Basel III banking regulations and the 2017 European Central Bank’s supervisory leveraged lending guidance, which stipulate banks should only lend to low-risk companies with less than 4x leverage.

Where banks need to reduce the risk associated with loan portfolios, they have two main options: originate-to-distribute and originate-to-share. In the originate-to-distribute model, banks typically arrange covenant-light deals and do not retain any of the borrower’s assets on their books (in other words, they don’t have ‘skin-in-the-game’). In the originate-to-share, or ‘parallel lending’, model, banks share part of their relatively low-risk assets with an asset manager (and maintain significant skin-in-the-game).

In parallel lending, the asset manager co-lends alongside a bank, but the bank keeps all the capital light or capital free business that usually comes with a loan. This allows the bank to use its balance sheet more efficiently. The result is a true partnership that benefits both parties.

A sizeable market opportunity

Given the bank-centric nature of the European economy, we estimate the potential market for parallel lending is more than €500 billion.³ This is larger than the European high yield and syndicated loan markets and almost double the size of the unitranche and mezzanine markets. We believe this provides a significant opportunity for asset managers working alongside banks as it offers a high penetration rate into the real economy.

The model also offers asset managers access to a significant number of deals because their investment platform is connected to the European-wide bank network, enabling them to choose what they believe are the most attractive loans on a risk-adjusted basis. This synergistic scenario is particularly relevant for the European economy, which is both bank centric and heavily dependent on middle market companies.

A low-risk approach to private debt?

Parallel lending allows managers to build high-quality portfolios relatively quickly but with the comfort of the tighter regulatory environment governing bank lending. For an asset manager working alongside a bank, every loan in which it participates as a co-investor is aligned to its own risk appetite. As a result, it is possible to construct strategies where the average quality of the portfolio is equivalent to investment grade (average leverage 2.5x). This is in stark contrast to certain segments of the US market where average leverage can be as high as 7x.⁴  

Diversification is another key feature. A parallel lending portfolio can have 100+ assets. As the portfolio is so granular, the maximum exposure to each holding is relatively low, which should minimise tail risk. Working with a European-wide banking network also means the portfolio is geographically diverse, spreading jurisdictional risk.

A less-crowded segment

Although the European banking network offers a large pool of loans, parallel lending has relatively high barriers to entry, requiring a strong local presence to undertake independent due diligence and a broad network of close relationships with regional banks. Such an approach necessitates a deep understanding of the local lending environment as bank practises differ from region to region.

To date, and because of the barriers to entry, competition from alternative asset managers is limited. While a few local asset managers in France, Italy and Spain can co-invest or compete with banks, we believe we are the only independent asset manager with a broad parallel lending presence in Europe. For many years, we have had a local presence in key countries and established strong relationships with more than 50 banks across Europe. This gives us a first-mover advantage.

Another important requirement for asset managers is having internal credit rating models in line with the Basel III banking regulation. This is a key point that helps avoid any material information asymmetry between co-lending banks and asset managers.

Sourcing, origination and screening

Given the size of the opportunity set, accessing it requires a stringent and disciplined investment process, along with the ability to combine qualitative and quantitative components to screen thousands of potential deals.

Local teams, located near borrowers and lending banks, who know the local laws, regulations and language are needed to source, structure and negotiate deals and conduct fundamental and cashflow analysis. A risk team, which applies rating tools to calculate the probability of default and assesses risk-adjusted pricing discipline, is key to maintaining investment discipline. It is important to keep in mind that banks occasionally misprice deals for commercial and relationship reasons.

Diversification does not assure a profit or protect against loss.

Applying artificial intelligence helps us further enhance the investment process via a multi-layer neural network/deep learning tool, so-called because it learns from a wide amount of data (Big Data) and provides augmented investment inputs. The AI tool can build an in-depth picture of good and bad companies and ultimately learn to predict which ones are more likely to default. This process of continuous learning improves the effectiveness of investment decision making. 

In summary, a robust and multi-layered investment process, combined with a local presence creates a favourable environment for disciplined decision-making and strong investment outcomes.

Regulatory benefits

Today, private credit is an established part of corporate lending. However, the progressive shift in lending from regulated banks to unregulated asset managers, is resulting in increasingly vocal calls for more stringent regulation of the private debt asset class.⁵

The potential impact of regulation on private credit is unclear. Nevertheless, it could be argued parallel lending is already subject to supervisory scrutiny because an asset manager is lending alongside a regulated bank in a traditional senior-secured loan structure.

We believe parallel lending can provide a diversified and relatively low-risk credit strategy that offers the potential for very compelling risk-adjusted returns.

References

1. Basel Regulations apply to 28 member states, as at January 2024.
2. Financial Stability Board – Non-Bank Financial Intermediation Report, December 2023. Latest available data used.
3. statista.com, as of September 2022. Most recent data available used.
4. S&P Global, as of 1st May 2024. Rising global defaults will test private credit funds in 2024.
5. Global Financial Stability Report, as of April 2024. The rise and risks of private credit.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of December 2024 and may change without notice.

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