Direct Lending Funds Ready as Europe’s Banks Tighten Lending

Dry powder for direct lending far outstrips other private debt strategies. More conservative policies from other lenders should provide a much-needed boost to deal flow

Direct lending funds targeting Europe stand to benefit from tighter lending criteria at eurozone banks. Over the past eight years, direct lending has emerged as the dominant strategy of Europe-focused private debt, with assets under management (AUM) surging from $9.0bn as of December 2012 to $138bn as of June 2020. Growth in AUM at direct lending funds outstripped that of distressed debt funds (up from $13bn to $53bn) and special situations (up from $14bn to $35bn) in the same period.

Direct lending funds provided more stable returns than other private debt strategies, as Fig. 1 shows. Funds of vintages 2011-2017 have maintained median net IRRs between 7.6% and 8.8%, which are relatively high compared to other fixed-income markets, but also steady. The 5.0% standard deviation of net IRR is the lowest of any private debt strategy.

Last year European direct lending funds struggled to deploy capital, with the amount of available dry powder increasing 30%, from $44bn at the end of 2019 to $63bn at the end of 2020 (Fig. 2). This was in marked contrast to both special situations, where dry powder fell from $13bn to $11bn, and distressed debt, which slipped from $16bn to $14bn. The liquidity pumped into the system as COVID-19 spread made private debt, already a relatively expensive form of credit for companies, less competitive. Additionally, many firms were able to avail themselves of supported loan schemes.

A build-up of dry powder translates into increased competition, lower pricing, and weaker terms and conditions, which in turn puts significant downward pressure on returns. There are, however, signs that the flow of opportunities will increase as banks tighten their purse strings. The January 2021 bank lending survey (BLS) from the European Central Bank reported more stringent credit standards, particularly for SME loans, and a rise in non-performing loans, with an increasing proportion of banks expecting further tightening through Q1 2021.

Although this may worsen credit availability and terms for borrowers, it is good news for direct lending funds and investors, who will be able to step into any spaces vacated by banks.