The Big Thaw: The path ahead for European private debt

November 6, 2024

If you have any feedback on this article or are interested in subscribing to our content, please contact us at opinions@muzinich.com or fill out the form on the right hand side of this page.

--------

After a challenging period for dealmaking, European private debt could be on the cusp of a recovery, as Kirsten Bode and Rafael Torres explain.

The last two years have seen a stark dichotomy within the European private debt market, with robust investor appetite and strong returns on the one hand, but constraints to origination from higher inflation and interest rates on the other.

Assets under management (AUM) surged from $271.5 billion at the end of 2019 to $427 billion in December 2023.¹ This momentum shows no signs of waning, with estimated annualized growth of 7.8% through 2029, potentially bringing the market size to $668.5 billion. The increased participation of retail investors² and banks³ (including in partnership with specialist asset managers) is further fuelling demand.

Simultaneously, investors have enjoyed consistent returns, with compound annual growth of 8.5% since 2019, punctuated by a single negative quarter at the onset of COVID-19.⁴ Again, the prospects of this continuing are encouraging. According to Preqin, European direct lending strategies are expected to see average internal rate of returns of 12.3% between 2023 and 2029, which would make it the strongest-performing region for the asset class.⁵

Origination has been challenging, however. Rising interest rates in 2022 and 2023 to combat inflation stifled sponsor-driven M&A activity — the primary engine of private debt transactions in Europe.⁶ Transactions involving lower-middle market companies held up better than for larger companies,⁷ but it was far from a fertile period for origination. The effects of this spilled over into the early part of 2024, with Q1 seeing just 117 completed transactions.⁸

But now, with the European Central Bank again in rate-cutting mode, there are grounds for optimism. In the second quarter, completed transactions more than doubled to 246, signalling a thaw in market activity.

Lower-middle market sweet spot

Although attention continues to centre on mega-sized strategies in the upper-middle market, increased competition within that segment and from the broadly syndicated market is putting downward pressure on margins and upward pressure on leverage. According to Bloomberg analysis, spreads on larger private credit loans have tightened by at least 100 basis points since early 2023, with the spread on new transactions falling below 500 basis points (bps) in some cases.⁹

By contrast, lower-middle market spreads have remained stable; based on our experience, it is unusual to see deals with spreads below 600bps. Leverage is also declining among lower-middle market companies, with recent Deloitte data showing a 5.8% increase in deals with leverage less than or equal to 4x.¹⁰

In our view, creditor protections in the lower-middle market are also more robust than the upper-middle market; S&P recently noted there is a negative relationship between the size of companies and covenants.¹¹

Origination: on the rebound?

After the recovery in European transaction volumes in Q2, much will depend on sponsor-driven M&A activity. While this could be uneven in terms of sectors and countries, at a broad level we believe the signs are positive.

Firstly, with private equity firms sitting on record levels of dry powder,¹² there is increasing pressure on them to put that money to work. Falling rates mean lower debt-financing costs - good news for potential buyers. At the same time, lower rates should feed through into an improvement in portfolio company cashflows and valuations, which should encourage sellers.

According to reports, M&A advisors are more optimistic of a recovery in activity now than at any point in the past three years.¹³ This corresponds with what we are hearing from advisors in our network.

Secondly, there has been much noise on the entry of major banks into the private credit arena this year, directly and through partnerships with specialist lenders.¹⁴ Far less attention, however, has been paid to upcoming changes to Basel III regulation, which will increase the regulatory capital required by banks to absorb unexpected losses on their lending activities. This could have significant implications for private credit.¹⁵

If banks have to offload non-compliant loan portfolios or execute significant risk transfers with third parties, it could offer a new avenue for direct lenders to source deals outside the traditional channels.

Inflection point

Despite the challenges of the past two years, we believe the European private debt market stands at an inflection point, with the evidence pointing to a rebound in activity.

In our view, the most attractive opportunities lie in the lower-middle market, where the combination of stable margins, low leverage and strong creditor protections could lead to superior risk-adjusted returns compared to the upper-middle market.

More broadly, the European private debt market remains an integral part of the economic and financial landscape. By providing flexible funding solutions to well-managed, small and medium-sized companies, we believe the asset class will continue to play a pivotal role in facilitating growth across the region.

“The European private debt market stands at an inflection point, with the evidence pointing to a rebound in activity.”

 

References

1.Preqin, ‘Future of alternatives 2029,’ September 18. 2024
2.Preqin, ‘Future of alternatives 2029,’ September 18. 2024
3.Private Debt Investor, ‘How banks are pivoting to compete,’ May 9, 2024
4.Lincoln International, as of April 23, 2024. Period covers 1st January 2019 - 31 March 2024, based on Lincoln European Senior Debt Index (ESDI). ESDI is a subset of the Lincoln Senior Debt Index, which tracks the performance of senior debt issued by 5,000 companies in the US and Europe. Most recent data available used.
5.Preqin, ‘Future of alternatives 2029,’ September 18. 2024
6.Baird, ‘Big Deals are Back – 10 Predictions for European PE,’ August 8, 2024
7.Boston Consulting Group, ‘M&A Insights H1 2024,’ July 9, 2024
8.Deloitte Private Debt Deal Tracker 1H deals, as of Autumn 2024
9.Bloomberg, ‘Private Credit Is Eyeing Bigger Margins on Loans,’ August 10, 2024
10.Deloitte Private Debt Deal Tracker 1H deals, as of Autumn 2024. Based on change in leverage in last twelve-month comparison (LTM) as of December 2023 and LTM June 2024
11.S&P Global, ‘Documentation, Flexible Structuring Continue To Reign In Private Credit,’ September 17, 2024
12.S&P Global, ‘Private equity dry powder growth accelerated in H1 2024,’ July 12, 2024
13.Dealsuite, ‘European M&A Monitor,’ September 2024
14.Private Debt Investor, ‘How banks are pivoting to compete,’ May 9, 2024
15.Macfarlanes, ‘Basel 3.1 – fuel to further accelerate the growth of private credit?’ September 12, 2024

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 November 2024 and may change without notice.

--------

Important information

Muzinich and/or Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. Muzinich views and opinions.  This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

This discussion material contains forward-looking statements, which give current expectations of future activities and future performance. Any or all forward-looking statements in this material may turn out to be incorrect. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Although the assumptions underlying the forward-looking statements contained herein are believed to be reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurances that the forward-looking statements included in this discussion material will   prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Further, no person undertakes any obligation to revise such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

United States: This material is for Institutional Investor use only – not for retail distribution. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.

Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. 2024-10-25-14789