Direct lending’s next chapter

The market opportunity for direct lending has grown significantly over the last decade, both in the US and in Europe. Direct lenders have filled a gap left by commercial banks, which scaled back on leveraged loans to middle market companies in the wake of the global financial crisis and have continued to deleverage. Now the COVID shock is shaping up as another milestone in the market’s development. Stephan Caron, Head of European Middle Market Private Debt, shared his assessment as part of our recent webcast, The dynamic opportunity set in credit. The following is adapted from his conversation with Mark Everitt, Head of Investment Research and Strategy for BlackRock Alternative Investors.

Can you give us a snapshot of conditions in your market?

In the primary market, deal flow has reduced significantly over the past six to eight weeks in both the US and Europe. Most LBO processes have been put on hold, with sponsors keeping lenders engaged to restart processes after the summer. Lenders are still assessing how to price risk in the face of continued uncertainty.

The relatively few new deals in the current market environment typically include increased yields. They also have lower leverage and other improved lender protections. As you would expect, these are generally businesses with exceptionally strong fundamentals.

Many private debt managers are focusing on preserving the value in their existing portfolios or reserving capital for defensive investments rather than underwriting new opportunities on the scale that they previously did.

As we consider the impact of COVID-19 on various sectors, there is a wide range of possible outcomes. Some sectors will take an extended period of time to recover. The auto sector, travel and leisure and casual dining are all likely to operate below capacity for a long time and won’t be immune if there’s a second confinement period later this year. There will also be fundamental changes in consumer behaviors, and the impacts will be different in each sector.

What’s the picture for the banks, and how does that affect your market?

We see increased constraints on their ability to lend, especially in Europe. Unlike in the US, where corporates can rely on a variety of different non-bank lending sources, in Europe corporates are still very dependent on the banks for their financing needs. Banks are required to manage exposures to these companies within a risk-weighted-asset framework, and COVID-19 is pushing them up against their limits.

Corporate customers have been tapping their undrawn credit facilities to increase their liquidity buffers. Banks also face increasing pressure in dealing with covenant breaches and unprofitable customers.

The low-rate environment that seems here to stay is further limiting the financial flexibility of European and US banks.

In the short term, banks have been lending to companies with loans guaranteed by governments—up to 90% of the principal amount in the EU, and even up to 95% in the US, with the “Main Street” program from the Fed. But overall, we have seen banks retrench back into their home markets. This will create an even bigger opportunity for direct lending firms to fill the gap going forward.

As you look ahead, what themes are you seeing?

Despite all the uncertainty, we can turn to our playbook from previous crises to identify those investment themes and sectors that have shown resilience and generated positive outcomes. From experience, the best vintages usually arise after a significant market correction, when there is less competition and better terms are available.

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From experience, the best vintages usually arise after a significant market correction.

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One theme we see across both the US and Europe is the likelihood of more public-to-private opportunities. With attractive public companies trading at depressed valuations, private equity sponsors are going through their screens to identify those companies that would be more valuable under private ownership.

We expect to see attractive buy-and-build opportunities in the EU. There are still many fragmented industries in the EU, where companies with low market share are now under pressure and may be acquired by market leaders. Sectors ripe for consolidation include software and technology, healthcare, the food industry and insurance brokers. These are all sectors where valuations for smaller companies with a low market share will become more attractive.

Which industry sectors are you focused on?

As discussed earlier not all sectors are being hit in the same way, and some sectors are to a large extent insulated from the current crisis. I’ll highlight two sectors that we believe will continue to see growth and show resilience as proven during previous cycles.

The first is software and technology. Data is the new must-have resource and we can also expect higher IT spending than pre-COVID and a wave of investment in critical infrastructure and future tech.

For example, we recently looked at a company focused on planning, building and servicing fiber networks in Germany. Germany is in the infancy stage of its fiber roll-out, with penetration significantly below EU peers (2.3% vs. 14% EU average, according to FTTH Council Europe) and it is estimated that it will take 15 years to reach 90% of household penetration. This is a key requirement for long-term economic growth, with €12bn of state aid earmarked for the fiber rollout, and the urgency has only been reinforced with the current crisis. In the US we looked at a manager of an online marketplace that provides staffing (primarily contract labor) and services to a variety of power verticals. These are examples of sector themes that will continue to grow and show resilience in the current environment.

Healthcare companies are another focus. They are on the front line of this crisis. They must face it daily, lead us out of it and figure out the longer-term implication and shifts. It’s also proven to be a recession-resistant sector, with a lot of data showing that PE investments in healthcare generated higher returns during the GFC than companies in other sectors, both in the US and EU, and by extension this has resulted in lower default rates for lenders. It is reasonable to expect that governments will come to appreciate health more as an economic resource and will need to increase funding for infectious diseases and epidemiology-related issues. There will also be increased willingness to tolerate market access and profitability for products that can play a role in the prevention and treatment of future pandemics.

It will take domain expertise, however, to distinguish potential winners from potential losers within these sectors. Some subsectors will benefit from the new normal. Some are currently hit hard but may rebound. And some will struggle.

Let’s dig deeper into healthcare. Which sub-segments are attractive?

We see great investment opportunities in three areas across the healthcare value chain:

In services, we think telemedicine, home healthcare and urgent care will become the new normal post COVID, while primary care, ambulatory surgery centers and diagnostic centers will see pent-up demand post-crisis as patients increasingly seek care in outpatient settings.

In med tech we see near term demand to address the crisis creating long term demand to increase inventory levels in PPE, sterilization and control and hospital equipment. We expect to see a return to normal in dental, diagnostic imaging and surgical instruments with a return of patients who have delayed those procedures.

In pharma, the big firms will need to rethink their supply chains and diversify their manufacturing footprint, bringing them closer to home. This will create opportunities for contract manufacturing organizations. They’ll need innovation in R&D to treat new diseases, so we expect increased spending on data and analytics and virtual clinical trials. We’re more cautious when it comes to generics and specialty pharma where we could see more pressure on reimbursements.

Healthcare IT spending is likely to continue along the lines of the general software trend, with use of data to address such issues as patient throughput /patient triage, which was difficult to manage at the peak of the crisis. Payer IT, supply chain IT and population health analytics should also be growth areas.

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We see great investment opportunities in three areas across the healthcare value chain.

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The demographic theme of ageing populations across many developed countries provides further attractive investment opportunities. An example we looked at in the US is an independent distributor of senior-focused insurance and retirement products to the elderly population. That type of service isn’t going away regardless whether the economic recovery is a V shape, U shape or any other letter of the alphabet.

Stephan Caron
Head of European Middle Market Debt
Mark Everitt, CFA
Head of Investment Research and Strategy, BlackRock Alternative Investors

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