Analysis: European private loan market falters as corporate credit stress mounts

Federated Hermes

07/09/2023 06:10

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      Private debt fundraising and deals slow
    

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      Industry tested by new high rate environment
    

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      Lending squeeze set to aggravate default risks
    

  
    By Naomi Rovnick and Chiara  Elisei
       LONDON, Sept 7 (Reuters) - Direct lending, a key but
expensive source of credit for riskier European firms that banks
often shy away from, is running out of steam, a fresh sign that
aggressive interest rate rises may be starting to cause funding
stress and exacerbate economic pain.
    Fundraising and deal-making have dropped sharply at European
private debt funds, new data shows.
    The European private credit industry, which flourished after
the 2008 financial crisis as capital-constrained banks cut
lending, has raised 26.1 billion euros ($28.02 billion) of new
investment so far in 2023, according to data provider Preqin. 
    That represents a 34% drop on the same period last year and
follows a record 2022 for capital raised by the sector. 
  
  
    
    Private lending is declining as euro zone banks cut loan
creation and business activity falters. 
    The M3 broad measure of euro zone money supply declined in
July for the first time since 2010. The Bank of England is
concerned about a funding squeeze in non-bank lending. 
    "We think that in the next two quarters, financial
conditions will deteriorate meaningfully," said Francesco
Sandrini, head of multi-asset strategies at Amundi, Europe's
largest asset manager.  
    The European Central Bank has delivered 425 basis points
(bps) of tightening this economic cycle and the BoE more than
500 bps. Now, those moves are beginning to bite. 
 
   
    
     Direct lenders, which overwhelmingly fund private
equity-backed and mid-market businesses, closed just 111
transactions in the second quarter of 2023, new data from
Deloitte shows, down 48% from the same quarter last year and the
lowest since Q3 2020. 
    Deloitte corporate finance debt advisory director Andrew
Cruickshank described private financing as now "tougher to
arrange", a likely indication of pain ahead for business owners
wishing to borrow and leveraged companies seeking to replace
maturing loans.
    Deals are "taking longer than they have traditionally", he
said, adding Deloitte was seeing an "uptick" in private lenders
demanding debt-for-equity swaps, the practice of taking
ownership of a business when borrowers struggle to repay debt. 
    Private loans could pick up later in the year, Cruickshank
said, but were unlikely to reach levels that would "reverse what
has been a poor year to date". 
  
  
    
    DEFAULTS 
    The lending squeeze reinforces expectations that corporate
defaults will rise. Fitch Ratings sees a default rate on
leveraged loans of 8.5% by the end of 2024, up from 1.7% in
July.
    Private debt funds charge borrowers a hefty premium above
benchmark euro zone lending rates, with yields now exceeding
12%, Pictet says.
    Patrick Marshall, head of fixed income for private markets
at Federated Hermes, anticipates tighter liquidity ahead.
    "You will see lenders in certain sectors of the industry
dealing with their own portfolio issues," instead of making
fresh loans, he said. 
    European companies backed by private capital are now
spending around 36% of their earnings before interest and tax on
debt payments, up from 23% in 2021, Fidelity International
estimates.
    Faisal Ramzan, a partner at law firm Proskauer Rose who
advises private credit funds, said he was not seeing default.
But, he added, in the past "three or four months" lenders were
starting to "get closer" to companies with weakening prospects
to "try and head off anything that's coming down the line".     

    DRY POWDER 
    Private credit fund managers express caution about deploying
funds in their 300 billion euro market. 
    "There's plenty of dry powder," said Fidelity
International's head of private credit strategies Michael
Curtis, referring to capital raised already. "It's more a
question, for us, of finding the right deals to do."
    Joanna Layton, managing director of European private credit
at Alcentra, one of Europe's largest private debt managers,
added there was "no rush" to deploy capital.
    This year so far, she said, was marked by direct lenders
"all being quite cautious".     
    
    HIGH-RATES TEST
    Some industry insiders noted Europe's private lending market
has not lived through a high interest rate environment.  
    Mark Brenke, a 20-year veteran of private funding markets
and head of private credit at $150 billion asset manager Ardian,
said most European direct lenders "will only have a track record
going back to 2012 or 2014".      
    Euro zone and UK rates are running at 23- and 15-year highs,
respectively. 
    High rates have also made private credit less appealing to
institutional investors, analysts said. 
    When 10-year Treasury yields ran below 1% in 2020 and below
2% in early 2022, pension funds and insurers used private credit
to create extra income, said Chris Sier, chief executive of
asset management consultancy ClearGlass Analytics. 
    But with institutions now earning north of 4% on Treasuries,
Sier said, "they need less of this risky asset class and that is
a reason certainly not to buy any more." 

  ($1 = 0.9314 euros)

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Funds raised by European private credit lenders    https://tmsnrt.rs/3r5tbbq
European private debt deals European private debt deals    https://tmsnrt.rs/45UwJfs
M3 Money supply growth euro zone    https://tmsnrt.rs/3sJUpFd
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 (Editing by Dhara Ranasinghe and Catherine Evans)
 ((Naomi.Rovnick@thomsonreuters.com;))