Introduction
The direct lending market has witnessed strong growth over recent years. In this article, we outline our assessment for the year ahead. We show how the direct lending market is evolving into an important financing vehicle to support the transformation of small- and medium-sized enterprises across multiple sectors of the European economy.
This paper is organised in three sections: the first examines the size and market opportunities for the direct lending with a particular focus on sector deals. The second section explores the prospects direct lending can provide for the European transformation, highlighting the leadership of the Nordic region when it comes to the renewable energy and digital transformation.
The final section assesses the characteristics of the sustainability loan market which offers the possibility that direct lending strategies can deliver real world sustainability outcomes such as greenhouse gas emission reduction. We also highlight the challenges with tracking and verifying company performance against specific key performance indicators that need to be addressed to support the long-term growth prospects for this market.
1 / Market size and outlook
According to industry estimates[1], the size of the private debt market globally is expected to grow to an all-time high of US$2.8 trillion by 2028. In terms of composition, direct lending constitutes approximately half of the global private debt market with the remainder of the market made up with instruments such as distressed and mezzanine debt.
Market activity
Direct lending demand is driven primarily by private equity. In the past few months, the private equity landscape has been confronted with several challenges. Geopolitical instability, political uncertainty, and a gloomy economic outlook have all affected valuations of companies and their ripple effects are still being felt[2]. Exits take longer as a greater valuation discrepancy persists, and market sentiment remains muted. While it is true that private equity is experiencing a trying period, funds are still able to allocate and have found creative ways to generate liquidity and performance in periods of market stress[3].
Although returns for private credit can currently yield more than private equity according to some sources, the mutual dependency warrants a more differentiated perspective on the state of private markets rather than a simple snapshot[4]. The uptick in activity in the fourth quarter of last year can serve as a positive sign of more deals to come, which should translate into more deals on the private credit side. Calls that private equity is not as relevant as before and that private credit is going to play a larger role seem premature and, given their relationship, misplaced. The recognition of private credit as an attractive asset class does not have to precipitate a reevaluation of private equity’s value. The asset classes are intertwined and rely on one another to differing degrees and should be examined accordingly. Private credit certainly does not have to shy away from any comparisons with other credit instruments given its attractive return and enduring value amid turbulent markets.
Sectors bias towards non-cyclicals
The trend that non-cyclical sectors are still in vogue has intensified in the European direct lending landscape. Hence, securing funds for other sectors has become even more challenging, for example, sectors that are consumer facing[5]. Chemicals have also been affected by a more cautious approach of lenders who are prioritizing stable businesses[5]. However, looking ahead, DWS analysis indicates that although non-cyclical sectors are still dominating the deal pipeline, change is afoot and more deals are being set up or struck in the consumer sector.
Sector agnostic perspective on the market may play out in General Partners favor to ensure that the best relative value is the driving force behind sourcing and structuring deals, instead of blindly following the trend of defensive features. However, geographical differences apply, high margins and the selective approach are making direct lenders look expensive. Meanwhile, banks are staging a comeback, especially in the lower mid-market, trying to claw back some of the market share they have lost in recent years[6]. As a result, sector diversification and fending off competition from banks can be strong arguments for re-assessing the credit worthiness of sectors and their associated risks. Nimble private debt lenders may salvage this momentum to lend to strong businesses in ‘weaker’ sectors. The speed and flexibility of private debt gives lenders more options to explore more cyclical sectors, because pre-cautionary measures can be taken, and tailor-made agreements can be fashioned at ease.
Caution in an uncertain macroeconomic backdrop is understandable and prudent. However, it should not lead to presumptive assumptions about business models operating in ‘riskier’ sectors, as each deal depends on the individual nature of the business and the deal structure. Factors such as market position, business model within the value chain, quality of management and strength of cash-flow profile should be considered first. Other key aspects for the risk assessment are sponsor commitment, leverage levels and the strength of covenants.