The flow of capital into European private credit during the last 10 years has been extraordinary. Focusing on the direct-lending segment of private credit, covering both senior and unitranche strategies, assets under management (AUM) were a cumulative €3.0bn in 2010. 

To illustrate the relative size of this source of capital for European SMEs, in 2010 it represented just c.0.7% of the outstanding SME loans across the UK, France and Ireland (by way of a reference sample). 

By 2020, this relative measure had increased to c.23% or c.€135bn in AUM. By June 2023, AUMs had expanded by a further 45% to c.€197bn. That represents a compound annual growth rate of c.38% or a 65x multiple of AUMs since 2010. 

While these growth numbers are extraordinary and represent a very real form of new supply of debt capital to European businesses, the headline numbers mask an asymmetry of distribution of this capital among the various parts of the market. 

We would broadly define four distinct parts of the direct lending market in Europe with the following transaction size characteristics:

Lower midmarket (LMM)
Ebitda: €2-10m
Typical leverage: 3.0-4.0x Typical deal size: €10-25m 

Midmarket
Ebitda: €10-25m
Typical leverage: 4.0-5.0x
Typical deal size: €50-100m

Upper midmarket
Ebitda: €25-75m
Typical leverage: 4.0-5.5x
Typical deal size: €150-250m

Large-cap
Ebitda: >€75m
Typical leverage: 4.0-6.0x
Typical deal size: >€250m

Defining these market segments is important as it allows for some consideration of where the majority of the €197bn of direct lending AUM has been or will be deployed. It is worth noting that dry powder balances stood at c. €46bn in June 2023. Some interesting facts to frame the discussion:

Average fund size for European direct lending has increased from €450m (across seven funds raised) in 2013 to €1.5bn (16 funds) in 2023. 

Of the 16 direct lending funds closed in Europe in 2023, eight or 50% (42% in 2022) were under $500m in size with cumulative AUM of c.$2.3bn, representing just 9.4% of total AUM closed in 2023 ($2.5bn or 7.7% in 2022).

Kroll recently noted that 45% of all deals completed in the 2nd half of 2022 were greater than €100m in size. Given the ever-increasing size of direct lending funds, it is not surprising that average transaction sizes are increasing as managers seek to deploy ever larger amounts of capital within defined investment periods.

In a recent survey, law firm Proskauer engaged with c.50 private credit firms in the UK / EU and 178 firms globally. Some 13% of respondents indicated that their maximum deal size was under $50m and 17% of respondents indicated that the average Ebitda level of portfolio companies was less than $15m, suggesting that a large proportion of market participants are focused on segments other than the LMM.

Deloitte, in its spring 2024 issue of the Private Deal Tracker, noted that less than 20% of deals in Europe were in support of sponsorless deals. That number is considerably lower in the UK at c.10%. While PE activity is robust in the LMM, it touches only a fraction of the c.237,000 medium-sized enterprises across the UK / EU.

Given the ever-increasing size of direct lending funds, it is not surprising that average transaction sizes are increasing as managers seek to deploy ever larger amounts of capital within defined investment periods

What is evident from the above is that most of the direct lending capital raised in recent times is not focused on the LMM. This implies limited relative supply as compared to the other segments of the direct lending market. Demand for capital remains robust, as evidenced by record dry powder in private equity funds and the ongoing demand for debt capital from LMM borrowers across the UK/EU who are no longer adequately served by traditional banks in their domestic markets. 

Common misconceptions about the LMM include:

More competition: To the contrary, as outlined above, there is less competition for transactions given the notably smaller number of managers focused on the LMM. The white space in the LMM has only grown during the last five years as larger private credit managers continue to get larger with only a limited few remaining steadfast in their focus on the LMM. Market bifurcation is clearly very evident in European direct lending. Further, given the nature of the European market, being a collection of individual legal jurisdictions, competition by geography in the LMM can also vary substantially with very attractive, underserved markets, throughout the region. European banks, which provide c.70% of funding to the LMM, continue to pull back because of changes in regulation including the impact of the Capital Requirements Regulation and Capital Requirements Directive.

Higher risk: Smaller means riskier. Size of the borrower is often cited as the key risk associated with LMM lending, given the conflation of default risk with size, but there is limited data to support the assertion that size alone is a key indicator of the likelihood of default. The accepted drivers of default risk are business risk and financial risk. Business risk includes internal factors such as management quality, corporate governance, operating efficiency, profitability, cashflow conversion and external factors such as country- and industry-specific risks. Financial risk is the quantitative and qualitative assessment of a borrower’s ability to service and repay loans. Financial risk can be assessed by a company’s cashflows, liquidity, earnings and asset quality. So, while size alone is not the key driver, there is little doubt that default risk is positively correlated with leverage, particularly in a high(er) interest- and inflation-rate environment.

What differentiates LMM lending from other segments of the direct lending market?

The LMM product offering is not treated by borrowers, be they financial sponsors or owner managers, like a commodity to be defined only by its cost. Rather, its value is seen initially as delivering certainty of execution with a trusted partner and subsequently as an enabler of enterprise-value growth.

Relationships matter – close relationships between borrowers and lenders with alignment of interests engrained not only in underlying loan documentation but also longevity of relationships between market participants are crucial.

Diligence underpinning a transaction is extensive with material input from lenders as to the scope of such diligence. Access to management teams is facilitated from the outset, allowing LMM lenders to get much closer to the inner workings of their potential borrowers. This is a critical success factor in underwriting as it allows a more forensic approach in determining what might go wrong in an underlying business.

Lender protections in loan documentation are extensive and materially stronger than those found in the larger parts of the direct-lending market. Financial covenants are more extensive, are set with less headroom against a robust financing case (with growing Ebitda) and with less scope for manipulation via adjustments to Ebitda. Additional debt incurrence is very limited, as is scope for asset leakage/stripping that might undermine recovery values in a workout scenario. It is interesting to note that 42% of respondents to the Proskauer 2024 survey indicated they would consider covenant-‘lite’ transactions. These were global respondents and when focusing on UK / EU direct lenders that number falls to 29%.

As discussed above – the underlying borrower is characterised as having Ebitda and turnover of less than €10m and €50m respectively. A positive factor worth considering in the context of size is the relative complexity of workout scenarios with such borrowers. While no workout is very straightforward and requires the adept application of skills gained only via experience, high recoveries and thus low loss given defaults are greatly aided by a lender’s ability to quickly assert control over all aspects of a borrower’s business. In this context, smaller businesses with less structural and operational complexity lend themselves to relatively more successful workouts.

Less leverage and higher pricing leading to compelling relative risk-adjusted returns with margins per turn of leverage typically in excess of 200bps. This is of course before considering reference rates (SONIA or EURIBOR), which would result in a coupon (margin plus base rate) per turn of leverage in many cases of above 300bps. These levels are above those available in other segments of the direct lending market and indeed the public high yield and leveraged loan markets.

Unique opportunity

There is a very clear structural supply/demand imbalance that exists in favour of direct lenders, particularly those active and experienced in deploying capital in the European LMM. This presents a unique opportunity for private credit investors who are prepared to look past some of the common misconceptions associated with LMM lending. 

Size alone is not a driver of default risk and while there is certainly data to support that borrowers in certain industries and with particular financial profiles are more prone to default, these are factors that an experienced LMM manager can identify early and use to frame their selection process. 

True alpha and compelling risk-adjusted returns can be generated by an experienced LMM manager with the skillset to originate and underwrite high quality credits from the vast opportunity set that exists in the LMM. A manager’s track record and, in particular, success in achieving high margins per turn of leverage together with low default and, in the event of something going wrong, high recovery rates, will demonstrate their ability to deliver on these often overlooked and underappreciated aspects of LMM direct lending. l

Ross Morrow is a co-founder and executive director of DunPort Capital Management, a specialist LMM lender operating across Ireland, the UK and the Benelux markets