Private debt: an investment partner even in challenging economic times

As tough economic times are putting the squeeze on traditional bank loans and effectively shuttering the CLO market, Europe’s small & medium businesses are increasingly turning to private debt funds to finance their growth plans. Vivien Buttiaux, Valérie Ducourty and Maxime de Roquette-Buisson explain what’s driving the market, and the criteria for a successful investment strategy.

European SMEs seek alternative financing options from private debt providers

Private debt funds can be an important ally to companies in times of economic stress, raising the prospect of rising demand for the asset class.

As it becomes harder for many companies in Europe to raise bank financing, due to the combined impact of solvency rules, capital requirements and justified concerns about the economic outlook for small & medium-sized businesses especially, so alternative sources of financing are growing in importance.

Worries about a rise in default rates are growing as the flood of cheap money dries up and companies find themselves having to pay back the state guarantee loans delivered through banks that kept them going through the Covid pandemic.

This means a wave of restructuring and insolvencies might now begin, putting further pressure on the bank financing sector. At the same time, a lack of visibility going forward has caused the CLO market to all but dry up, therefore reducing the debt liquidity on the large cap market.

Of course, this isn’t the first time that private debt as an asset class finds itself facing new demands to fill the gap for debt financing. The same phenomenon hit hard after the 2008 financial crisis, when banks’ balance sheets were put under severe constraints.

SMEs spotting opportunity in times of crisis

It isn’t simply these constraints on the banks and CLO market that are fueling the appetite for private debt today. There is likely to be a significant demand for debt financing from companies of all sizes looking to take advantage of the current upheaval. An economic crisis may threaten many companies, but for some it can also present significant opportunities for market consolidation or expansion.

When entrepreneurs spot such an opening, for example to make a “buy & build” acquisition, they need to move quickly. At such sensitive moments, the ability of private debt funds to be more flexible and nimble than banks in their approach makes them an important ally for the entrepreneur and management.

Other elements are also driving demand for private debt. First, some entrepreneurs are reluctant to seek financing from equity investors under current valuations, all the more so for those reluctant to cede majority control or even to simply open their capital to financial sponsor.

Second, private debt funds enjoy the ability to offer those companies quasi-equity solutions, such as mezzanine debt, which today is once again a relatively attractively priced financing option. This is in part thanks to higher interest rates on senior loans and also because quasi-equity solutions provide a more suitable structure of repayment for some medium-term projects.

Third, even though the pace of their fund raising has slowed recently, private equity funds which have raised significant amounts in commitments from their limited partners in recent years, will continue to deploy equity on new deals, driving further demand for debt financing of leveraged buyout transactions.

Public market turmoil sparks an asset reallocation

Upstream from the private debt funds themselves, institutional investors reviewing their asset allocation strategies are themselves facing some questions. The recent turmoil on the public markets has caused a mark-down in their liquid assets, inevitably leaving many overexposed to illiquid asset classes such as private equity and private debt. The consequent need to readjust their portfolios to bring them back within their investment guidelines will be prompting many investors to rethink their allocation strategies for 2023.

For investors considering renewing or expanding their exposure to the private debt market, the key questions to ask before selecting fund managers should now focus on their investment teams’ longevity and track record in the market, and above all their recovery rates, proving their ability to work with borrowers through tough times and steer them back to solvency.

In such times of crisis as we are currently witnessing, no borrower will be immune from shocks, and so the private debt lenders operating in the market today must be able to show that – over the years, through difficult periods such as the 2008 financial crisis and the 2020 pandemic - they have displayed the means and the know-how to lead a restructuring, working with management and finding solutions.

This depth of experience will be key as lending conditions shift under the dual impact of a rising demand for private debt on the one hand, and the increased sensitivity of borrowers to the risks of higher interest rates. Both GPs and lenders have already reverted to a more cautious approach to financings, notably a careful assessment of prospective borrowers’ interest coverage ratios, an important KPI easily overlooked when money was cheap.