Demand for private debt in Europe has exceeded other regions in recent months. Bouncing back after a weaker Q2, in Q3 2019 Europe-focused private debt funds secured a total of $14bn, significantly outpacing North America ($6.5bn), Asia ($1.5bn) and the rest of the world ($0.1bn), according to Preqin data. And with half of active private debt investors targeting the continent over the next 12 months – vs. 41% targeting the US for example – Europe dominates other parts of the world.
But what is the outlook for the private debt market as the European economy weakens further? How are top-tier firms preparing for a downturn? What risks and opportunities lie ahead? For an industry expert’s point of view, we spoke to Daniel Heine, co-founder of Switzerland-based alternative investment firm Patrimonium and Managing Director of its Private Debt business.
Patrimonium launched its first private debt fund in 2012 at €200mn, providing senior-secured loans to Mittelstand (mid-sized businesses) in Germany, Austria and Switzerland. How has your investment strategy evolved since that first fund?
Let me go further back, before 2012, to explain where our company came from. We started in 2005, providing mezzanine loans mainly to middle-market corporates based in Germany. Before the 2008 Global Financial Crisis, we were one of the largest providers of mezzanine facilities to this segment of the market. Everything we have done has to be seen against that background, because many of the mezzanine providers did not survive 2008-2009. For the survivors, it was very important to apply the lessons learned.
The fund we launched in 2012, Patrimonium Middle Market Debt Fund, was our first reaction to the pre-crisis experience we had managing mezzanine funds. This fund targeted special situations, and it was an asset-based lending strategy, where you are providing debt to companies without credit metrics in place. You can do that because as part of the risk mitigation you receive hard assets, collateralized security. This strategy performed extremely well for us and in successor funds, we still have the same strategy.
You’re currently raising another special situations fund, Patrimonium Middle Market Debt Fund II, targeting €350mn. What has investor sentiment been like for this strategy?
We’re doing a second close and we’re already over the target amount. This is a good indication of how institutional investors perceive the market at the moment. I think there’s a certain appetite for special situations funds, because everybody is getting a bit cautious. The big question is, when will the credit cycle end? Of course, you want to be prepared as an investor.
This year you launched your first Private Debt Co-investor Fund with around €200mn alongside Credit Suisse. Next year, there will be a successor Fund with a €600-800mn target. What is the rationale for these types of funds?
These are private debt funds where we invest alongside and pari-passu with the Credit Suisse balance sheet. I think it’s a very synergetic and also a state-of-the-art cooperation between a bank and a private debt fund, because each party can fully contribute their strengths without being in competition. The instruments we are providing are typical bank loan structures – revolving credit facility (RCF) lines, term loan A and term loan B instruments – which are very straightforward and are on the conservative end of the private debt universe. We are exclusively investing in the weaker end of the rated borrower base, the single Bs and double Bs. It makes sense for Credit Suisse to share the exposure, and we are able to achieve commensurate returns in a universe which was previously inaccessible to non-bank institutional investors.
Our evolution very much reflects the development of the private debt market in Europe as a whole. Private debt funds emerged to provide capital and fill a gap in the market. That began with mezzanine loans, then after the financial crisis it became special situations and direct lending.
What impact is Germany’s slowing economy having on the direct lending market?
There are a few elements to consider. First, Germany is an export nation. Reduced Asian demand, and Chinese demand in particular, is having a negative effect on both the German and the European economy.
Second, there are some major structural changes happening. A big issue that Germany’s automobile industry faces this year is ‘model change,’ which is when car manufacturers start building new models as previous ones reach the end of their lifecycle. In 2019, this model change is away from the combustion engine and toward electrical engines. This is having a dramatic effect on the automotive supply industry, which is very large in Germany. Default rates in the automotive supply industry are going up dramatically because of this change, and I think lenders have to be very cautious about financing the automotive supply sector.
A third element to look at is the structural change going on in the German banking system. The big banks are slimming down; Commerzbank for example is closing around 40% of its German subsidiaries. The state-owned Landesbanken is also undergoing major changes: e.g. HSH Nordbank, one of the largest providers of credit to the Mittelstand in Northern Germany, was sold to a group of US private equity firms including Cerberus in 2018.
In combination with regulations such as the Basel III and Basel IV accords – which require banks to provide more equity or Tier 1 capital – the Mittelstand, the backbone of the German economy, is now underserved by traditional lenders. That creates opportunities for private debt funds targeting the middle market.
How can private debt players make the most of these opportunities?
There is the old saying that credit is a local business, and it’s true. I think a pan-European strategy is doable as long as you’re working alongside financial sponsors, but in the world of sponsorless lending, you need to be very local. You need to be present in all the major European jurisdictions and you need to know the local language, the local legal system.
That’s why we focus on the German-speaking countries. We will gradually look at neighboring countries, the ‘beer drinking’ countries you might say, in contrast to the ‘wine drinking’ countries. Step by step, we are slowly but surely going across the borders to the Netherlands and to Belgium. Working with Credit Suisse, with its European loan book, our portfolio is becoming more European.
What can lenders do to protect themselves at a time when business credit ratings are weakening?
We are seeing increasing deal flow, because more businesses are failing to qualify for traditional bank lending facilities. The remedy for direct lenders providing credit to companies with weaker credit metrics is having some form of security, and today that means hard assets.
Germany is a good country for this, because the Mittelstand companies are mainly family businesses in their second, third or fourth generation, and over the decades they have accumulated assets related to the production of machinery, goods and tools. There is less of a worry about credit metrics because your recovery values are sufficiently high.
Earlier you mentioned that private debt players that survived the 2008-2009 financial crisis learned important lessons. Can you give an example?
I’ll give you a scenario. Let’s say a company is acquired by a sponsor and the equity cushion is relatively small, because the sponsor paid an extremely high EBITDA multiple for the business.
As a lender you’re asked to provide a large unit tranche on this transaction, which is a combination of a senior and a mezzanine loan.
Say the company gets into trouble, EBITDA decreases, and the equity value is getting close to zero. The company needs additional liquidity, cash. What will happen? Will the sponsor happily put in more money? I assume not. If we look at what occurred in 2008 and 2009, when additional cash was needed, everybody at the table looked around and said: “What is your contribution?”
Thus, I would reckon that the mezzanine end of the unit tranche will to some extent be asked to chip in something, exactly as it happened in 2008-2009. This is the situation we want to stay away from. This is why we focus on the sponsorless segment of the market, where you see fewer aggressive unitranche structures and stronger covenant structures.
Let’s talk about fundraising. According to Preqin’s latest Private Debt Quarterly Update, Europe is attracting more private debt investors than other markets, including the US. What do you think is driving this interest?
I think Europe is 10 or 15 years behind the US market in private debt, and it’s now catching up. The Nordic market is very advanced – institutional investors in Finland and Denmark have existing allocations for private debt and they are very sophisticated. As you move to the middle of Europe, let’s say Germany or Switzerland, institutional investors are in the process of creating those private debt allocations.
Why is Europe further behind the US? Europe’s banking system never went through a massive overhaul the way US banks did after the savings and loan crisis in the 1980s. Now, though, European banks are going through structural change. This means the middle market is increasingly being served by private debt funds, and that makes Europe a very attractive market for private debt investors.
How is your investor base changing as the European private debt market develops?
We have a very large and strong Nordic investor base. These are very experienced investors that already have exposure to US private debt funds, and now that the European market is maturing, it has become an option for them.
Another very attractive investor market for us is South Korea, where we see very good momentum and interest – these are also big investors, the insurance companies and large pension funds. We’ve also found that Israeli investors are starting to look at European debt funds.
Given Europe’s softening economy, what is your outlook for private debt returns going forward?
If I compare what I see now to 2006-2007, I think lending discipline is still intact if you exclude some exuberance at the aggressive end of the unitranche universe. I don’t believe we have reached a level comparable to what we saw in the years before the financial crisis. The risks are around increasing competition for the larger and mid-market players, and undeployed capital trying to seek its way into the market, which can push returns down.
What we have not yet seen, but may see in future, is defaults. I think that's natural if the economy is weakening Europe-wide, and that will lower returns. But overall, I am still relatively optimistic on the overall market.
Why is that – what positive indicators do you see in the market?
First, if you look around Europe, in most cases capital is deployed from plain vanilla, mostly unleveraged funds. Before 2007-2008, however, most of the capital came from CLO (collateralized loan obligation) structures. In a typical pre-crisis CLO structure, you were looking at 5-10% equity, and the rest was leverage. Those structures are much more sensitive to defaults.
An unleveraged fund is a way more resilient structure. And this is the reason why regulators in European countries have realized that it makes a lot of sense to allow credit funds to provide loans. Take the German example. In previous years, credit funds weren’t allowed to provide loans because you needed a banking license. But now BaFin (the German financial regulatory authority) understands that loans from unleveraged funds are much more resilient compared with a bank balance sheet, which is a highly leveraged structure. Even if we see a few defaults, the effect on a portfolio level with up to 30 positions means it can be managed.
The reality is that Europe is still a very small, growing market. Competition isn’t an issue in the lower mid-market and returns continue to be strong. Bottom line, if you stick to your lending principles and if you apply a cautious approach, I think overall the asset class will continue to look very favorable to investors.
Daniel Heine is a founder of Patrimonium and Managing Director of the company’s Private Debt business. Prior to the company’s formation, he worked as a Financial Consultant for Merrill Lynch International and before that, as a management consultant at A.T. Kearney. He studied Business Administration at the University of St. Gallen and received a Master of Arts from the University of Oxford. He also holds a Ph.D. of the University of St. Gallen.