The following item is by Daniel O’Donnell, the global head of private equity and real estate research and management, at Citi.

The following item is by Daniel O’Donnell, the global head of private equity and real estate research and management, at Citi. This item expresses the views of the author and is not necessarily shared by the editors of this news organisation; however, it is grateful for these insights and invites readers to respond.

A reduction in lending by European banks and contraction of the collateralized loan obligations (CLOs) market - both large providers of debt capital - has created a potential funding gap for European companies.  This funding gap creates an opportunity for non-bank institutions to provide secured financing with potential attractive risk adjusted returns to investors.

Europe offers a higher risk-adjusted return potential than the US for this opportunity.  Specifically, European loans may provide better covenant protection and wider margin premiums of up to 225 basis points.

However, there is no guarantee that these returns will be achieved. Investors should carefully review and consider potential risks before investing.

Amidst a backdrop of financial regulatory reform, banks have started deleveraging order to meet new capital requirements. For example, regulations such as Basel III are expected to lead to a 3.5-times increase in the amount of common equity that banks need to hold by 2019.  As a result, banks are lending less to European companies, even in countries where economic growth has resumed. As they reduce their exposure, banks are increasingly bringing other institutions into their lending syndicates. Notwithstanding this trend, banks will continue to be the dominant source of debt capital for European companies for the foreseeable future.

The CLO market, the other main source of debt financing for European corporates, is also contracting. There has been a relative dearth of new European CLOs issued since 2008, which means that within 18 months, over 90 per cent of existing European CLOs will have finished their investment period.  

Despite signs of a nascent recovery in CLO issuance in 2013, the levels are nowhere near those before 2008. Notably, any new European CLOs will be governed by stricter regulations, reducing the scale of their investment programmes.  The combined impact of reduced lending by banks and CLOs is significant: a net reduction of €333 billion ($454 billion) since May 2012.

This reduction in credit availability, coupled with increased demand for debt capital, may create an attractive environment in which to lend to European companies. European sub-investment grade companies need to refinance approximately €200 billion of leveraged loans and high yield bonds between 2013 and 2016. The total refinancing requirement could exceed €430 billion through 2020 if we include borrowers who issued debt while rated investment grade but are now considered sub-investment grade.  The UK funding gap alone is estimated to be between £84 ($114.6 billion) and £191 billion over the next five years.  As a result of the excess demand for debt capital, an opportunity exists for non-bank institutions to provide new loans to European companies on attractive terms.  

The move towards non-bank institutional lending in Europe mirrors that which has been experienced in the US, beginning in the early 1990’s. The US market is currently dominated by non-bank institutions and is more competitive and liquid than Europe. As a result, loans have lower margins, lower equity contribution, and greater prevalence of terms which increase risk to lenders such as “covenant-light” arrangements.
As was the case in the US, the European shift to a competitive market lead by non-bank institutions is likely to be gradual and may take up to two decades.

We believe the best risk-adjusted return opportunities to be from lending to mid-market European companies (earnings before interest, taxation, amortisation and depreciation of  €15 - 75 million).  Such firms can have a lower risk profile than small to medium enterprises (SMEs), since they typically have access to broader management talent, levers such as working capital and capital expenditure which can be managed in the event of an economic slowdown, and greater revenue diversification by country and industry.

Mid- to large-sized firms (EBITDA greater than €75 million) generally offer a lower risk profile than SMEs and mid-market companies, but these companies have a variety of debt financing options,  including high yield issuance and the US debt markets.  As such, margins and terms are currently less attractive for lenders than in the mid-market; yields have compressed to approximately 5 per cent annually.  Further, if the mid to large-sized company loan market is accessed via open ended fund structures, there may be an additional risk of an asset-liability duration mismatch.  Investors in open ended funds with monthly liquidity can suffer if there are significant redemptions and the fund cannot sell loans quickly enough.  In this instance both the client and the fund suffer, as funds can falter, become more illiquid, or have to set up side pockets.

When done properly, investments in mid-market loans are expected to benefit from higher margins and upfront fees than larger company loans.  Also, mid-market banks frequently take an active role in negotiating loan terms including their covenants; typically on a private, bi-lateral basis.  This results in potentially better covenant protection than some large company loans.  However, making loans to mid-market companies requires significant sourcing and diligence resources.  Mid-market loans are typically sourced from banks, despite the banks reducing their lending exposure to European companies.  As a result, non-bank lenders that have strong relationships and experience lending alongside banks could have a sourcing advantage.

We believe Europe-focused primary lenders currently provide the potential for attractive risk-adjusted returns. By partnering with a well-positioned firm focused on Europe, investors may be able to benefit from upfront fees and higher yields, with secured collateral providing downside protection.

However, an investment in alternative investments can be highly illiquid, speculative, and not suitable for all investors. Investing in alternative investments is only intended for experienced and sophisticated investors who are willing to bear the high economic risks associated with such an investment. Investors should carefully review and consider potential risks before investing.