A revolution in the European business financing model is underway. As banks retreat and downsize in the face of new regulations and overburdened balance sheets, direct lending is emerging as a new and superior source of funding for mid-sized European companies.

The business financing market in Europe is changing rapidly. Defying a playing field historically dominated by banks, a growing number of funds are now lending directly to medium-sized European companies.

The United States is already experiencing this kind of insurgency. Non-bank lenders accounted for only 37% of US leveraged lending activity in 1998. They now represent over 85% of this market.

The European market for non-bank loans is still far behind its American counterpart. Source: Intermediate Capital Group, M&G Investments

In the EU, non-bank lenders only grant around 20% of business loans. This, however, is rapidly changing. From 2012 to 2015, the number of European managers engaged in direct credit to companies increased from 45 to 85. In 2014, 59% new loans were granted by institutional investors rather than by banks.

KKR, the US-based private equity firm, is at the forefront of this push. He issued more than $ 500 million loans to European companies in 2015.

Europe’s share of global capital raised for private debt has grown rapidly. Source: The Economist

Many other private equity funds have also started to diversify into private debt. Of the $ 158 billion in deployable capital – or “dry powder – in private debt funds last year, about a third was for European debt.

With banks in retreat and starving investors in abundance, the surge in private debt funds is an unstoppable force. It’s a quiet revolution, but a revolution nonetheless.

What is the direct loan?

Direct loans refer to loans granted to businesses by non-bank institutions. It is often asset managers who allocate funds raised for this specific purpose.

Targeted companies tend to be in the middle market, or those with a EBITDA somewhere in the range of 5 to 75 million euros. This focus is due to the more competitive nature of large business loans. The behemoths can exploit the corporate bond market when looking for large loans or attract the attention of large capital intermediaries, such as investment banks, more easily than smaller firms.

Direct lending generally focuses on lower quality loans in the middle market. Source: Deloitte

Direct lending is often done under the guise of a private equity sponsor. This means that loans are either issued to finance the buyout of a business by a private equity fund or to businesses with private lenders. However, non-sponsored loans are becoming more and more prevalent. Currently representing 24% of total transactions, this share is anticipated to reach 30% over the next two years.

There is a huge pool of capital that unsponsored businesses need for expansion, refinancing or acquisition. To tap into this, private debt funds began to set up their own credit infrastructures, allowing them to analyze credit opportunities and perform their own due diligence. Those who undertake the necessary investments are likely to be duly rewarded: Standard & Poor’s estimates that medium-sized European companies will need up to € 3.8 trillion in financing by 2018.

A declining banking sector

The 2008 global financial crisis was the spark that ignited the old established order. The new Basel III capital rules have increased the cost for banks to issue medium-term loans to medium-sized companies. The intense deleveraging in the banking sector has compounded this forced withdrawal of loans to medium-sized companies.

Bank financing costs have increased since the 2008 financial crisis. Source: M&G Investments

With the doors open, direct lenders are emerging to fill the void. While banks traditionally have a natural advantage as lenders due to their low cost of funds, these non-bank lenders are not just a stopgap.

On the one hand, the new capital rules are here to stay. Private debt funds are not exempt due to a legal vacuum. Contrary to popular belief, private debt managers are not shadow banks: investors are blocked, and funds are therefore not subject to crises of confidence.

Pocket funds can also offer businesses multiple rounds of financing and build lasting relationships with their borrowers. This is crucial if they are to replace banks as a source of capital for medium-sized family businesses in Europe, which tend to place particular emphasis on stability and predictability.

Moreover, direct lenders are not simply a substitute for banks. On the contrary, they offer a differentiated product in the form of more flexible arrangements, increased speed of execution and longer deadlines. Contractual clauses can be tailor-made and adapted to the needs of borrowers.

An attractive asset class

The boom is largely due to renewed interest in the asset class. Investors with long-term commitments are attracted by the large liquidity premium offered by these assets. In an age when some sovereigns borrow at negative rates, relatively safe direct loan investments can offer attractive single-digit returns. Investments in private debt are also a source of diversification for bond portfolios. They exhibit a low correlation with public debt and in turn provide a means of increasing risk-adjusted returns.

Likewise, private debt has proven to be attractive beyond its role as an alternative source of fixed income. Some investors have allocated capital into direct lending funds from private funds, alternative investments and even hedge fund compartments.

An increasing number of large pension funds are beginning to have specific allowances for private debt. Large financial intelligence firms report that 65% of institutional investors surveyed intend to increase their allocation to private debt over the long term. Those who dipped their toes in 2015 have nothing to complain about: 90% said the returns on their private debt portfolios had exceeded their expectations.

Looking forward

European direct lenders have yet to be tested by the widespread defaults that will ensue when the next recession hits Europe. The resilience of the asset class as an attractive alternative may depend on the ability of managers to collect their contributions when the cycle reverses and borrowers restructure.

The boom can be expected to subside as the field becomes more crowded and yields come under pressure. Interest in private debt in the United States has waned in recent years as intense competition has driven yields down.

Nonetheless, direct loan funds are here to remain an important source of finance for medium-sized European companies. Investors should hurry while the returns are rosy; it won’t be long before they are inundated with latecomers. Markets are not known to offer abnormal returns in the short term. For European companies dependent on their local bank for the financing of projects and acquisitions, let’s face it: there is a new source of credit in the city.