European private credit: Waiting for the next big leap

June 12, 2024

European private credit: Waiting for the next big leap

In our latest Q&A, Kirsten Bode and Rafael Torres share their thoughts on the prospects for European private credit.

The European private debt market has experienced a meteoric rise in the past decade, increasing almost 400% from US$92 billion at the start of 2014 to US$459 billion in June 2023. Much of this growth has been driven by direct lending, which has seen an almost tenfold increase, from US$26 billion to US$274.3 billion, to now account for 60% of the region’s private debt market.^[1]

According to a S&P Global survey of 370 institutional investors published in April, 61% said they will increase their allocation to private credit in 2024.^[2] Preqin estimates that for the 2022-2028 period, European direct lending will see annualised growth of 15.6%.^[3]

The rise of private credit has been accompanied by consistent returns. Between January 1, 2019 (the earliest date for which data is available) and March 31, 2024, the Lincoln European Senior Debt Index (ESDI) saw compound annual growth of 8.5%, experiencing only one negative quarter  at the onset of COVID-19 in Q1 2020, when it fell 1.4%.^[4]

Despite challenges to borrowers caused by rising interest rates since early 2022 as central banks sought to contain inflation, defaults have been kept relatively modest. While not broken down by region, the percentage of private companies tracked in the Lincoln Senior Debt Index defaulting on covenants fell from 3.4% in the final quarter of 2023 to 2.5% at the end of Q1 2024, continuing a trend of declining defaults since they hit 4.5% in Q1 last year.^[5]

Past performance is not a reliable indicator of current or future results.

Index performance is for illustrative purposes only. You cannot invest directly in the index.

Nevertheless, higher rates have caused a slowing of M&A activity involving private equity sponsors, who account for over 90% of private debt deals in the UK and around 80% in the rest of Europe.^[6] As of April 30, private equity dry powder in the region totalled US$295.1 billion, according to Preqin, which estimates there are currently 1,750 acquisition targets for European sponsors. This was likely a key factor behind the weakest start to the year for private debt fund closes since 2016.^[7]

But with sponsors under pressure to put that spare capital to work, and European interest rates back on a downward path after the European Central Bank on June 6 announced a 25 basis points cut from 4% to 3.75% to its key policy rate,^[8] the question of when private credit will see another wave of M&A-driven activity seems to be a matter of when rather than if.

To discuss this and more, we put the questions to Kirsten Bode (KB) and Rafael Torres (RT), co-heads of private debt, Pan Europe, at Muzinich.

Where do you currently see opportunities?

KB: Our asset class is always evolving and always interesting. If you look at the lower-middle market,^[9] which is where we focus our investments, it has shown resilience during the 2008-2009 global financial crisis, the European sovereign debt crisis, COVID-19 and, over the past couple of years, a period of high inflation and rising interest rates.

While the broader market has seen a significant decline in M&A^[10] — which is the main driver of new deal activity in private credit — the lower-middle market was less impacted, which we observed through the deal introductions that came to us.

Larger players struggled to find transactions, leading to margin pressure, but margins in the lower-middle market remained stable. This stability in deal volumes and less competition in this segment is a supportive factor.

What we have seen over time is large private lenders focusing their efforts on larger borrowers and exiting the lower-middle market. Entering this part of the market is particularly challenging due to significant barriers to entry in Europe. For managers, it’s not just about your ability to raise funds but also having people on the ground in different jurisdictions, who understand the nuances of each country and the local business environment. For smaller deals, you need strong local origination and execution teams.

RT: Another trend we have observed is a decline in leverage. In our segment, unlike the upper middle market where transactions are still seeing leverage levels of 5 to 6 times, we typically see leverage of 3 to 3.5 times in the lower-middle market. This results in healthier interest coverage ratios. This is a powerful feature of our segment, indicating the high quality of credit we focus on.

As was highlighted in a major Moody’s study in 2021, while size is a consideration in assessing credit risk, other factors like leverage often play a more significant role.^[11]

According to Deloitte, European private lending activity has recovered to levels last seen in 2022, just as the ECB was about to start its rate-hiking cycle. What are the reasons for this, and do you expect this to continue?

RT: The uncertainty surrounding geopolitical conflicts and interest rates since 2022 had a significant impact on deal volumes in the broader market. However, what you tend to find over time is that market participants digest these issues and get used to living with complexity.

Fast forward to now, with greater visibility on what is likely to happen with interest rates, private equity activity is starting to rebound, which should trigger more financing activity on the debt side.

While the ECB recently announced its first cut in two years, there’s an expectation that rates will remain higher for longer. What impact do you see this having on origination and deal structuring?

KB: Private credit activity in Europe tends to be sponsor driven. Higher interest rates mean lower enterprise value multiples for sponsors, which has led to a pause on sell-side processes and impacted deal volumes.

However, at some point, private equity companies will need to sell portfolio companies to show returns to their investors. Even modest interest rate cuts could propel deal activity further and potentially increase leverage levels. For us, if a company can afford to repay a loan over five to six years, there is some scope for a modest increase in leverage. This might decrease the yield for investors, but the illiquidity premium still makes the asset class attractive.

What do you see as the most attractive characteristics of European private credit relative to other asset classes?

RT: Diversification and risk-reward are key selling points, in our view. Geographical diversification is something we focus on within our private credit strategies, whereas some competitors might have a narrower focus. The risk-reward ratio is attractive; for example, we can potentially deliver higher returns with leverage in certain markets, which is highly competitive with other asset classes.

KB: Additionally, our local presence across Europe is a strong selling point. Many Pan-European funds have limited teams, and you can find there is lot of portfolio concentration in one or two jurisdictions. 

We have a broader presence across multiple countries. This setup requires significant investment in people and coordination but we believe it provides a substantial advantage in terms of deal origination and execution. If you want to offer true diversification to clients, you want there to be little overlap with other managers on the deals in your portfolio.

There is a lot of attention on evergreen structures. Is that the future for the asset class in Europe?

RT: Both evergreen and closed-ended structures will likely co-exist successfully in the future. Evergreen structures offer significant benefits, in our view. On the institutional side, they diminish the need for continuous fundraising; on the private client side, including wealth and retail, they open up their access to new asset classes. That is the thinking behind ELTIF regulations in Europe and the Long-term Asset Fund rules in the UK.

The AUM of ELTIFs rose 24% in 2023, largely in private market assets, and is expected to rise to €30-35 billion by 2026, according to European fund rating agency Scope.^[12] It is still early days, but the signs are encouraging.

KB: The interest in evergreen structures will vary depending on the investor type. While they offer continuous capital availability and access to new investor types, traditional closed-ended structures allow institutional investors to make periodic commitments depending on their own circumstances. It depends on the investor's objectives and preference for liquidity versus a long-term commitment. In our view, there is room for both traditional and evergreen structures.

The European private credit market is largely sponsor driven. Do you see opportunities for non-sponsor transactions?

RT: We are having discussions with international investors interested in non-sponsor-backed middle-market deals. There is less competition, but it requires a strong local presence for successful origination and execution, with appropriate time and resource focused on this part of the market. We have the right structure and personnel to be successful, and it is an area we are looking at in more detail.

 

References

[1] Preqin, ‘Strategy in Focus: Direct Lending,’ as of June 3, 2024. Most recent data available used.
[2] S&P Global, as of April 29, 2024
[3] Preqin, ‘Strategy in Focus: Direct Lending,’ as of June 3, 2024. Most recent data available used.
[4] Lincoln International, as of April 23, 2024. 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.
[5] Lincoln International, as of April 23, 2024.
[6] Deloitte, ‘Private Debt Deal Tracker Spring 2024’, as of March 18, 2024
[7] Pitchbook, ‘Q1 2024 Global Private Market Fundraising Report,’ as of May 22, 2024.
[8] European Central Bank, as of June 6, 2024
[9] Lower-middle market companies defined as those with an EBITDA of between €5 million to €25 million.
[10] PWC, ‘Global M&A Industry Trends,’ as of January 23, 2024
[11] Moody’s Analytics, ‘Middle Market Lending Does Not Always Mean High Risk’, December 2021
[12] Scope, as of May 15, 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 June 2024, and may change without notice.

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