This site uses cookies.  By continuing to browse this site you are agreeing to our use of cookies.   Find out more.

Beyond Banks: The Emerging Opportunity in European Direct Lending

October 2013

Charles Dolan, CFA

Senior Investment Strategist, BNY Mellon Investment Strategy & Solutions Group*


Ralph Goldsticker, CFA

Senior Investment Strategist, BNY Mellon Investment Strategy & Solutions Group*


Chris Harris, CFA

Investment Solutions Strategist, BNY Mellon Investment Strategy & Solutions Group*

Executive Summary

The tightening of regulations around the world is prompting banks to offload a variety of financial assets onto the capital markets. This disintermediation process is giving investors access to investment opportunities that were previously the exclusive remit of banks. We believe that the investments being created by banks' partial withdrawal from lending offers attractive potential returns and supply and demand dynamics. While many investors are aware that disintermediation is taking place, we believe that some remain confused about the scale and timing of the opportunity. While conventional wisdom holds that this opportunity has played itself out, we believe that evidence shows this not to be the case. Over the next three years, the combination of maturities in the institutional loan market and private equity capital commitments means that supply in this area will easily exceed €100 billion in Europe, even in the absence of further European bank deleveraging. From the perspective of an institutional investor, we consider the liquidity, expected returns and other characteristics of these securities and offer practical approaches as to how they might best be incorporated into a portfolio.

Since the financial crisis, banking regulations have been tightened across much of the world in order to reduce the risk of another system failure. The myriad of inter- and intra-national regulations has incentivized banks to reduce their holdings of risky assets. This has created an opportunity for investors in capital markets to lend directly to companies, something banks had previously been almost alone in doing. Banks need to dispose of a large volume of assets, but the pool of potential capital market investors for some of these direct lending opportunities is limited. We believe this creates an attractive supply-demand dynamic and offers the potential for attractive returns.

Investors are aware of this opportunity. However, we think that many hold misconceptions about it because of the opaque nature of the disintermediation process, and the unfamiliar and heterogenous nature of the assets involved. In particular, we believe that investors incorrectly assume the opportunity has been missed and offer evidence that this is not the case. We also think that few investors have had the opportunity to fully understand the practical characteristics of the asset class. Our objective is to provide these details, and to explain how it might be incorporated into an institutional portfolio.

The Disintermediation Story So Far

The Basel III and Dodd-Frank regulations are the most prominent examples of a raft of regulatory actions designed to reduce the riskiness of banks and to prevent another banking crisis. The increased regulation makes it more expensive and difficult for banks to lend and they have responded by planning to reduce future lending to the private sector and by attempting to sell off existing lending arrangements as syndicated loans, direct loans or Collateralized Loan Obligations, (CLOs).1 For a company seeking capital, the alternative to borrowing from a bank is to borrow in the capital markets by issuing securities such as bonds or syndicated loans. Many larger companies can arrange bond issues and they have numerous willing lenders in the markets. Disintermediation presents neither a significant challenge for them, nor a new opportunity for investors.

We believe that the most attractive opportunities resulting from disintermediation are for direct lending to small and medium-sized companies, which have traditionally relied heavily on bank lending. These companies' borrowing needs are not large enough to make issuing bonds a viable option, but they still need funds. Direct lending means investment managers make loans to these companies on a one-to-one basis. These investments are likely to be illiquid, with no reliable secondary market. Investors maybe attracted to direct lending because of the likely imbalance between the significant number of would-be borrowers, often with an inflexible demand for funds, and the small numbers of lenders. But many of those potential investors have difficulty stomaching the illiquidity and unfamiliarity of this type of investment.

Figure 1 // Structure of the Direct Lending opportunity

Figure 1 // Structure of the Direct Lending opportunity

The imbalance between supply and demand is likely to be most acute in Europe and we believe investors interested in this opportunity should focus there. Bank lending has historically been the dominant source of private sector borrowing in Europe, and debt markets are relatively underdeveloped compared to those in the U.S. So far, there has been little construction of CLOs or other securities that might increase the capital available for corporate lending. In the first half of 2013, according to JP Morgan, European banks have created €2.4 billion worth of CLOs, far below the €35 billion they issued in the peak year of 2007.

Most Of The Required Disintermediation Has Yet To Occur

Investors considering direct lending may believe the opportunity has already passed them by. The disintermediation process is not particularly transparent, and few if any aggregated data sources show its progress. However, examining the situation in Europe, we do not think the supply and demand imbalance that makes these investments attractive has eased. Generally, investors have not positioned themselves to meet this opportunity, and asset management companies have offered them a limited number of vehicles for doing so.

We believe that the opportunity created by disintermediation continues to exist because banks have not yet begun to dispose of the bulk of the loans they will need to offload. Many of the Basel III regulations go into effect between 2016 and 2019, and banks have several reasons not to immediately start the process of bringing themselves into compliance. They may believe that over time, markets will become more welcoming to the assets the banks must sell and will demand less of a discount. They may also wish to start de-leveraging once their capital positions have improved. Selling riskier assets now could force them to realize losses versus the book value and make their capital situations look worse. In a 2012 survey of bankers2, most agreed that the bulk of de-leveraging in Europe would not occur in the near future (see chart below). A similar survey of investors suggested that the de-leveraging process would most likely take place between 2015 and 2017. The announcement at the start of this year that the Liquidity Coverage Ratio aspect of the Basel III regulations has been delayed may further extend the process.

Figure 2 // When will European bank de-leveraging conclude?

Figure 2 // When will European bank de-leveraging conclude?

Source: PwC

The asset management industry has thus far shown little more eagerness for disintermediation than have the banks. Many asset managers are not equipped to manage this novel investment opportunity, and some investors are unsure how best to take advantage of it. As of 2012, they had allocated an estimated €60 billion3 to take advantage of the expected €500 billion in European bank asset disposals. We therefore think that the attractive supply and demand dynamic, which drew investors' attention to this opportunity in the first place, still exists.

Extra Spread Is Equivalent To Several Levels Of Subordination

Quantifying returns for direct lending is difficult because the asset class itself is still forming. That is because it largely consists of relatively small, nonpublic companies, and because there is no public market for direct lending arrangements. However, we can use public data and anecdotal evidence to broadly outline prospective returns. Those outlines should be sufficient for investors to evaluate the opportunity and to determine how direct lending might fit in their portfolios. Though the pricing of the direct lending market is not transparent, the premiums and discounts for seniority or subordination in the corporate bond market can provide insights into the current pricing of the syndicated loan markets and the expected premium for illiquidity.

To look at how the capital structure is priced, we examined instruments spanning most of the corporate capital structure, which have a relatively high degree of price transparency. Figure 3 shows bond relative spreads for both USD and EUR bonds before and after the financial crisis. This allows us to observe the material increase in premia for subordination. Comparing USD and EUR shows that Europe, where the bulk of the de-leveraging process has not yet played out, has the larger risk premia differentiation across the various levels of the capital structure.

Figure 3 // USD and euro bond spreads before and after the financial crisis

Figure 3 // USD and euro bond spreads before and after the financial crisis

Source: BNY Mellon Research, BofA Merrill Lynch Investment Grade and High Yield Corporate Bond Indices

Data in Figure 3 are calculated using statistics from cross-sectional regressions of bond spreads against various bond characteristics: sector, credit rating and seniority (priority of repayment in the event of default) . The bond universes are BofA Merrill Lynch indices, investment grade and high yield, for USD and EUR respectively. The column labeled "BBB to BB" is the pickup in yield that one would gain by moving from BBB to BB rated bonds. The column labeled "Secured to Senior" is the pickup in yield that one would gain from moving from secured debt to senior unsecured.4

The "Secured to Senior" column shows the markets granting a larger discount for seniority in the capital structure. In the U.S., the spread widened by 22 basis points, from -9 to 13. The spread for Euro-based bonds widened by 29 basis points, from 4 to 33, despite seniority already being reflected in the rating. Even after accounting for both industry and rating, public capital markets are offering a significant discount to buyers of subordinated debt. Consistent with our assertion that the squeeze on borrowers in Europe will be much tighter; the premium for subordination is larger in Europe, 33 versus 13 basis points.5

The next step is to judge where loans are being priced relative to bonds. Loans are typically senior to bonds in the capital structure; they have higher priority in the event of default. Therefore, their credit spread should fall between secured and senior bonds. However, the spreads on loans are similar to senior bonds. Currently, spreads on loans rated BB or B are around 350-450 bps above LIBOR. Senior bonds of comparable credit quality for non-financial issuers are priced 300-450 bps over LIBOR.6 Based upon these estimates, loans clearly offer a competitive credit spread. Their spreads are comparable, but all else being equal, they are expected to have a higher recovery the event of default.

Finally, one should look at multiple sources to gauge the liquidity premium. We do this by evaluating aggregate Eurozone loan data, liquidity premia in other asset classes and anecdotal evidence.

Figure 4 // Liquidity spreads – private versus public markets

Figure 4 // Liquidity spreads – private versus public markets

Aggregate eurozone loan data, which include syndicated and large company loans, indicate a yield spread of 25-75 bps over publicly traded bonds of comparable quality. For general liquidity premia, our experience across asset classes is that liquidity is nearly always worth 100 bps. More specifically, we have found that in private equity, when adjusted for leverage, a 200 bps liquidity premium is available compared to publicly traded equity. Anecdotal quotes from participants in direct lending support our estimate that direct loans currently offer a liquidity spread of well above 100 bps, relative to the more liquid syndicated loan market.

In the absence of market prices for spreads in direct lending, we think that the advantages of direct lending over publicly traded debt can be characterized as follows:

  1. Markets are pricing an extra premium for subordination in the capital structure, boosting yields.
  2. Loans are currently attractively priced relative to comparable bonds. They have similar yield, but they are typically superior in the capital structure, and therefore investors may expect a higher recovery value in event of default.
  3. The illiquidity premium of direct lending results in a yield increase which is equivalent to several levels of subordination in the capital structure.

In summary, the compensation for direct lending appears to offer more than adequate compensation for the credit and liquidity risk.

Incorporating Direct Lending Into A Diversified Portfolio

A pooled fund of direct lending assets, rather than a segregated account, is likely the only available way to gain exposure to this opportunity. Diversification is important, and a pooled fund structure allows an investor to diversify across a range of direct lending assets and avoid excessive concentration of issuer and other risks. Investors may prefer segregated accounts in other asset classes, but the benefit is limited in direct lending because those accounts do not easily accommodate individual clients constraints.

The method an investor uses to incorporate direct lending into a portfolio will partly depend upon their tolerance for adding illiquid assets. Currently, we believe that sacrificing liquidity provides investors with an attractive gain in expected return. Therefore, investors who can sacrifice liquidity without jeopardizing their ability to meet liabilities should do so. However, even investors whose allocation to illiquid assets is already as high as they feel comfortable with may improve their portfolios by re-allocating some of the illiquid portion of their portfolio to direct lending. Below we outline asset allocation changes we believe can improve expected returns and/or reduce risk.

Direct Lending As A Replacement For High Yield Bonds

High yield bonds have enjoyed significant gains over the past few years, but credit spreads have now reached relatively compressed levels. Even after recent increases, government bond yields are far below their historical range. Although default rates do not appear to threaten expected returns, this combination of low interest rates and tight credit spreads means that loans are competitive with high yield bonds on an absolute basis as well as adjusted for risk.

Replacing high yield bonds with loans gives an investor a competitive yield, a superior position in the capital structure, and a floating coupon rather than a fixed one. The price of these advantages is a reduction in liquidity. In terms of spread to LIBOR, we currently see direct lending as being priced at least 120 bps higher than high yield, for a similar credit rating. Furthermore, the superior claim on capital in the event of default and the floating nature of the coupon help to reduce default risk and interest rate risk, respectively. The two main threats to investors' capital are thereby partially mitigated. We expect that the higher spread will persist for some time and that the liquidity premium for direct lending is unlikely to disappear. The spread advantage of loans over bonds will persist until structural issues such as settlement and pricing match those of bonds and investor flows and issuance reach levels comparable levels to bonds.

Switching From Other Illiquid Assets Into Direct Lending

For investors who have already reached their maximum allocation to illiquid assets, we believe there may be advantages to partially switching from other illiquid assets into direct loans. Such changes would be subject to the schedule at which other illiquid allocations could be reduced, since these assets are by definition not readily realizable. Switching from private equity to direct lending would likely increase diversification, reduce total intra-portfolio correlation and increase liquidity by shortening lockup periods and reducing contingent commitments. Switching from hedge funds to direct lending could offer more security regarding expected returns.

Figure 5 // possible asset allocation switches to accommodate the direct lending asset class

Figure 5 // possible asset allocation switches to accommodate the direct lending asset class


1 Syndicated Loans, in contrast to the direct loan asset class that is the focus of this article, are arranged between the borrower and a number of other par ties and of ten have a somewhat liquid secondary market. Collateralized Loan Obligations, or CLOs, are structured products that permit investors to own a defined part of a pool of loans. A good primer to the asset class is published by the Milken Institute.

2 Deloitte; Capital gain, asset loss: European bank de-leveraging.

3 PwC; European Investor Insights 2012

4 For the risk premia in Figure 3, most of the junior securities are issued by companies that also issue senior securities. Therefore, the estimated risk premia are a fair representation of the cost of seniority after taking into account other factors such as sector and rating. For mid-level companies, first lien loans might comprise the entire capital structure above equity. Therefore, an asset manager will take into account the lack of a cushion from other creditors when assessing a fair value spread. This additional feature of loans to mid-level companies will be considered by an asset manager and should be reflected in the spread received by investors. In practice, however, the blending of the capital structures for mid-level companies should not be a significant distortion relative to the spread components. Senior bonds make up a large percentage of the capital structure. For the broad US and European debt markets, senior debt is over 85 percent of the issuance, according to BoA Merrill Lynch. For HY debt, senior bonds are 70-90 percent of the unsecured debt across both European and U.S. companies.

5 Obtained from Bloomberg, as at end-June 2013

6 One difference between bonds and loans which is not accounted for in this analysis is the callability of bonds versus loans. Bonds typically have a call price of 1-3 points above par, but loans are callable at par. For consistency, all analyses presented here are done using OAS versus swaps in order to minimize any potential mismatch between bond and loan spreads.

* BNY Mellon Investment Strategy & Solutions Group ("ISSG") is part of The Bank of New York Mellon ("Bank"). In the U.S., ISSG offers products and services through the Bank, including investment strategies that are developed by affiliated BNY Mellon Investment Management advisory firms and managed by officers of such affiliated firms acting in their capacities as dual officers of the Bank.

BNY Mellon Investment Management is one of the world's leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon's affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. · The statements and opinions expressed in this document are those of the authors as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon, BNY Mellon Asset Management International or any of their respective affiliates. This document is of general nature, does not constitute legal, tax, accounting or other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon Asset Management International Limited and its affiliates are not responsible for any subsequent investment advice given based on the information supplied.

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested. · While the information in this document is not intended to be investment advice, it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for use by professional and wholesale investors only and not for onward distribution to, or to be relied upon by, retail investors. · Products or services described in this document are provided by BNY Mellon, its subsidiaries, affiliates or related companies and may be provided in various countries by one or more of these companies where authorized and regulated as required within each jurisdiction. Not all products and services are offered at all locations. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value. · This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management International Limited.

In Australia, this document is issued by BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865) located at Level 6, 7 Macquarie Place, Sydney, NSW 2000. Authorized and regulated by the Australian Securities & Investments Commission. · In Brazil, this document is issued by BNY Mellon Serviços Financeiros DTVM S.A., Av. Presidente Wilson, 231, 11th floor, Rio de Janeiro, RJ, Brazil, CEP 20030-905. BNY Mellon Serviços Financeiros DTVM S.A. is a Financial Institution, duly authorized by the Brazilian Central Bank to provide securities distribution and by the Brazilian Securities and Exchange Commission (CVM) to provide securities portfolio managing services under Declaratory Act No. 4.620, issued on December 19, 1997. · Securities in Canada are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager in Ontario. · In Dubai, United Arab Emirates, this document is issued by the Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended for Professional Clients only and no other person should act upon it. · If this document is used or distributed in Hong Kong, it is issued by BNY Mellon Investment Management Hong Kong Limited, whose business address is Level 18, Three Pacific Place, 1 Queen's Road East, Hong Kong. BNY Mellon Investment Management Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission and its registered office is at 6th floor, Alexandra House, 18 Chater Road, Central, Hong Kong. · In Japan, this document is issued by BNY Mellon Asset Management Japan Limited, Marunouchi Trust Tower Main Building, 1-8-3 Marunouchi Chiyoda-ku, Tokyo 100-0005, Japan. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. · In Korea, this document is issued by BNY Mellon AM Korea Limited for presentation to professional investors. BNY Mellon AM Korea Limited, 29F One IFC, 10 Gukegeumyung-ro, Yeongdeungpo-gu, Seoul, 150-945, Korea. Regulated by the Financial Supervisory Service. · In Singapore, this document is issued by The Bank of New York Mellon, Singapore Branch for presentation to accredited investors, institutional investors and family offices that are expert investors as defined under the Securities and Futures Act. The Bank of New York Mellon, Singapore Branch, One Temasek Avenue, #02-01 Millenia Tower, Singapore 039192. Regulated by the Monetary Authority of Singapore. · This document is issued in the UK and in mainland Europe, by BNY Mellon Asset Management International Limited, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority. · This document is issued in the United States by BNY Mellon Investment Management.

BNY Mellon owns over 95% of the parent holding company of The Alcentra Group, which is comprised of the following affiliated investment advisers: Alcentra, Ltd and Alcentra NY, LLC. · BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. · BNY Mellon Western FMC, Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms' services or funds to any U.S. investor, or where otherwise unlawful. · BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People's Republic of China. · BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. · BNY Mellon owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars Asset Management Limited and Hamon Asian Advisors Limited both of which offer investment services in the U.S. · Services offered in the US, Canada and Australia by Pareto Investment Management Limited under the Insight Pareto brand. · The Newton Group ("Newton") is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. · BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC). · BNY Mellon Asset Management International Limited and any other BNY Mellon entity mentioned above are all ultimately owned by BNY Mellon, unless otherwise noted.

© 2013 The Bank of New York Mellon Corporation. All rights reserved.