The rise of Private Lending, diversification of the lending market is maturing

Capital Advisory

From Ernest Partners

While loans were historically the prerogative of banks, the tightening of capital requirements imposed on banks by regulators in the aftermath of the 2008 global financial crisis has given rise to a parallel market of “direct” loans.

With higher capital requirement under Basel rules and IFRS 9, regulators imposed stricter binding rules on banks. This led to selective withdrawal of banks at the beginning of the COVID 19 epidemic. IFRS 9, which came into effect in 2018, has profoundly overhauled the impairment and provision calculations of banks. The new financial asset impairment model is based on the recognition of expected future credit losses. This measure therefore forced banks to record significant provisions at the beginning of the epidemic to deal with the higher risks of defaults. However, this rule generates a reflexive mechanism in the economy: banks do not have the financial and accounting means to lend to companies in a crisis, which leads to a liquidity crisis in those companies, resulting in an even greater default on loans. Fortunately, many European States have acted as guarantors for the loans requested by firms from the banks, which has reduced the risk for the banks and unlocked the financing of the economy during the crisis. What will happen when governments can no longer support banks and companies?

The extremely low interest rate environment and relatively flat yield curve has also put a negative pressure on interest margin, acting as another constraint on European banks.

As any entrepreneur, the corona crisis has also made banks nervous. The wait and see attitude of banks adding to the constraints leaves room for alternative financing solutions like Private debt.

A debt fund brings flexibility to the capital structure and solutions to the economy

A debt fund is structured similarly to equity funds, focusing on senior or subordinate debt to small and larger companies. They support a company when it comes to diversifying its debt structure, refinance the banks, or support its strategy. They have flourished in parallel to the growing legislation regarding the banking system. Indeed, the financial crisis have shown that many companies could not rely solely on the bank financing. In particular, the 2011 European debt crisis showcased two phenomena regarding the financing ecosystem: the credit crunch and the risk appetite decreased in search for more qualitative files.

While, in Europe, the disintermediated financing was only for large companies able to finance themselves on the public bond market, it has shifted toward the private middle market. Basically, every company with at least €5-10 million EBITDA is able to be financed by a debt fund. One of the reasons why US companies better survived the 2011 debt crisis is because 70 % of the US economy relied on disintermediated financing, while 70% of the European economy relied on bank financing.

The debt funds bring to companies an array of debt structures that could fit into its capital structure. Nevertheless, the company’s business model, be it heavy on assets or high free cash flow generating, the structure of the loan and its guarantees are flexible and adapted to the needs and capacities of the company. Debt funds can bring to the company easiness with unitranche financing, including in a one stop shop financing the full need of the company.  But if required they are also able to finance the company with both senior secured loan and mezzanine loan. In fact, the diversity of solutions brought by debt funds enables the management to choose which debt seniority and which reimbursement schedule fits best. Private loans may also refinance a portion of the shareholders equity. Although the private debt generally comes with a higher price, flexibility has made private debt loans a sustainable substitute for bank loans.

Debt funds are not only financing partners, they position themselves as strategic advisors. Indeed, they made an analysis of the business model and they provide the company with advice on the way the operational and financial performance could be enhanced. That is why debt funds enter in a long-term relationship with their partners. The fund will support the strategy of the company in the long term, be it a mergers and acquisitions strategy or a research and development strategy. In the same way, a debt fund will be able to support a company strategically and financially when business conditions deteriorate, providing additional financing or restructuration methods. Debt funds act as a business partner, where traditional banks operate more like a service provider.

Bank financing remains the main option when it comes to financing working capital and assets, the possibilities offered by banks to the companies are abundant, such as factoring or leasing. Are you looking to diversify your funding sources and willing to onboard a long term business partner, considering a private debt fund could be a smart move.

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Author : Sébastien D’Hondt

Author : Sébastien D’Hondt

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