19 July 2017
An allocation into direct lending can provide insurers a diversified source of higher, less volatile returns over a longer-term time horizon
Since the 2008 financial crisis, heavier regulatory burdens have resulted in the need for greater capital requirements and stronger risk management for banks and insurers.
These evolving dynamics have led to a structural shift in the European lending landscape as banks retreat from the market. But while the role of banks as lenders has reduced, the borrowing requirements of businesses remains buoyant and growing.
This has led to an increasing opportunity set for direct lenders - asset managers offering direct lending solutions who have stepped in to fill the lending gap left by the banks.
European bank loans to corporates has declined
Non-bank lending deals are increasing in Europe
The role of a direct lender can be seen as twofold. The first is to supply funding to businesses such as small-to-medium-sized enterprises (SMEs) seeking bespoke lending solutions. The second is to offer investors an alternative investment capability with an attractive risk-adjusted return profile.
The private debt market is not a new phenomenon, with sub-asset classes including mezzanine debt, special situations, real estate and distressed debt firmly established in the marketplace. However, the sub-asset class of direct lending in Europe is a more recent occurrence because it evolved as a result of the financial crisis.
While the concept is embedded in the US lending landscape, where direct lenders sit comfortably alongside banks as a source of financing, in Europe direct lending is still in its relative infancy. However, it is growing in popularity and, as we shall demonstrate, appears here to stay.
A long term, conservative investment allocation
In a world of low yields in traditional fixed income, direct lending funds offer an attractive alternative source of return on a risk-adjusted basis when considered as part of an overall portfolio allocation. As a result, insurance companies are showing increasing interest in these less-liquid strategies.
As central bank rhetoric turns increasingly hawkish, fixed income investors are looking for solutions that can provide protection from rising rates and market volatility. The floating rate features of the investment instruments within a direct lending fund mean they are insulated from moves in interest rates, while the illiquid profile provides protection from mark-to-market volatility. Investors are compensated for the latter with an attractive illiquidity premium, which leads to higher yields than liquid investments. The illiquid nature of the investment meanwhile sits well with the longer-term investment horizon of an insurer.
The capital and risk profile of the asset class is also more in-line with the conservative nature of insurers. Depending on the manager, debt can be positioned higher up the capital structure, which can offer greater protection against default. In addition, under Solvency II, direct lending can be classed as an unrated bond which is beneficial from a reporting perspective; an unrated investment may lead to better capital reserve treatment in contrast to other investments with similar risk/reward characteristics. An allocation into a direct lending fund can be seen as a great diversifier in helping insurance companies improve their capital efficiency.
A focus on origination
While we believe the opportunity set across Europe is growing in its appeal to insurers, how they execute their investment allocation is something that should be taken under careful consideration.
Although some have attempted to invest directly, many lack the requisite skillsets to originate deals and carry out due diligence, the flexibility to move on a deal and the ongoing management of the investments.
We believe a strong team of highly-skilled, dedicated investment professionals focused purely on structuring and executing the best deals is key to a successful strategy in this space. Lenders can have a direct impact on the businesses to which they loan money, as well as a more direct influence on the outcome of their investment.
Having a local presence in these markets is also vital in giving a lender the ability to invest into directly-originated transactions, as well as a greater understanding of cultures and jurisdictions. Therefore, we would encourage those considering an allocation into the direct lending space to approach a dedicated provider.
Here to stay
The European direct lending market emerged as a result of the ensuing chaos from the financial crisis. Yet we believe it is not a short-term trend. The financial crisis highlighted inefficiencies in the way businesses source capital, with the realisation thereafter that the system actually benefits from a diversified range of funding options. As we have witnessed in the US, we believe direct lenders can and do have a long-term role to play alongside banks.
This trend is being underpinned by a wave of changing regulations across Europe, making it easier for businesses to source capital from direct lenders. In the last two years Germany and Italy have relaxed the lending laws to allow non-banks to provide financing solutions. At the same time, we are witnessing tighter controls restraining bank lending activity still further.
Taking the US market as an example, we believe over the long term funding in Europe will be increasingly provided by the institutional finance market. Demand from SMEs is outstripping supply, which is providing a healthy technical backdrop and underpinning the long-term opportunity set.
In our view, direct lending appears here to stay. An optimal trend for both lenders and borrowers and, we believe, an investment opportunity for insurers.
Kirsten Bode, Private Debt Investments, Muzinich & Co.