Why direct lending funds should matter to Europe’s investors and entrepreneurs

No two small businesses are alike, and neither are their financing needs. A technology company with intellectual assets may lack the collateral for a ‘plain vanilla’ bank loan.

Or, a fast-growing business investing its early profits in acquisitions might prefer to make a single repayment at the loan’s maturity rather than smaller payments throughout the life of the loan.

The most innovative and fastest growing businesses often need a tailor-made finance package. However, banks’ business models hinge on processing a comparatively higher number of loans, which can make it impractical to structure bespoke debt packages. They are also restrained by capacity and may have limitations regarding their exposure to certain asset classes and sectors.

Although the bank approach hugely supports SME financing in Europe, it does not serve all. Direct lending funds offer small businesses an alternative to classic bank loans.

These funds structure bespoke debt packages for borrowers, managing their risk by investing in a diverse number of companies using a variety of debt transactions.

However, the number of direct lending funds that serve SMEs are limited, and they are not available everywhere. In order to make Europe a better place to be an entrepreneur, we need to ensure that more companies can access this flexible form of debt in their home territories.

Close ties

Structuring bespoke debt involves a deep understanding of the business itself and of its future plans. A direct lending fund may need to carry out a due diligence process in order to hammer out terms and conditions, possibly including covenants and protections, in order to measure and price the underlying risk. For example, requiring the business to maintain its leverage below a certain multiple.

In return, the direct lending fund can offer a speed of execution that allows companies to access their funds rapidly — in some cases as quickly as two weeks. It may also give guidance, support and even introductions to advisors that the business may leverage off in the future.

However, most of the fundraising activity for direct lending funds in Europe is still concentrated on France and the UK. This is in part historical, as these funds first materialised in these countries after the financial crisis, but is in part due to legal restraints. Not every country has legislation that promotes alternative debt.

Yet a local presence is crucial for the intimate relationship between borrower and direct lending fund.

What is also critical is that more funds are raised by new fund managers, so that SMEs can benefit from a diverse choice of direct lending funds, offering flexible debt structures, in a greater number of geographies.

New territories

Investors can be hesitant about investing in a relatively new asset class, in new fund managers, and outside the countries and jurisdictions that they know well.

This affects not just direct lending funds, but crowdfunding platforms, which fall into the same asset class. Given the opportunity to grow, both are an important source of alternative financing for SMEs.

The European Investment Fund’s Diversified Debt Funds programme was set up to support new funds by acting as a cornerstone investor, and this ‘stamp of approval’ from the AAA-rated EIF drew new investors into new funds. On average, each of the funds supported by the EIF’s Diversified Debt Funds activity had eleven investors by the end of their fundraising period.

Deals such as the EUR 18.5m investment in the diversified debt fund managed by crowdfunding platform, October, helped the fund raise EUR 90m — capital that provides more financing for SMEs.

The EIF is now continuing this work, with the new EFSI Private Credit Tailored for SMEs Programme. Set up with the European Commission, the programme will deploy EUR 1bn to diversified debt funds, and will use a combination of cash investment and other unfunded credit protections to attract new investors into this asset class.

The new product will particularly prioritise funds with a pan-European focus as well as funds that build more flexible financing structures into their offering. First time managers, countries where regulatory changes support the asset class, and origination through crowdfunding platforms is also important. This will help harness existing interest in the asset class — and grow it.

After all, as direct lending funds are growing into a recognised alternative asset class. According to a study by private capital markets platform Pitchbook, $52.6bn was raised in direct lending funds in 2017, the highest ever amount recorded.

Yet this is still the tip of the iceberg. There are vast amounts of untapped private capital in the trillions that could still be channeled into direct lending in other countries, particularly from institutional investors looking to put their balance sheet to work for a decent return.

The EIF’s participation builds confidence. When supporting new funds as a cornerstone investor, the EIF offers fund managers advise on market best practices and governance — analysing the underlying portfolio and encouraging the fund to implement portfolio covenants to improve the risk-return profile of the fund.

Banks are recognising the role direct lending funds can play in providing a wide variety of financing, partnering with funds in deals or referring their existing customer base to fund to help their client diversify their existing sources of finance.

This support creates a signaling effect, which encourages new investors to enter the direct lending space for the first time.

Be alternative

Small businesses need a choice of financing options if they are to grow successfully. By supporting a number of direct lending funds, the Private Credit Tailored for SMEs programme is expected to benefit over 2,000 small businesses in Europe.

Attracting new investors into this growing space will encourage greater penetration across borders, which will improve the financing conditions for SMEs in Europe — not to mention fulfilling Capital Market Union objectives which aim to encourage investment across borders. For investors, it links institutional savings with economic growth.

Europe is becoming a better place to be an entrepreneur than it was 20 years ago — with a flourishing venture capital market, increased bank lending and the rise in crowdfunding platforms. However there is still more to do. The flexible forms of debt available from direct lending platforms need to be available on a larger scale to make a meaningful impact.

To read more about the Private Credit Tailored for SMEs Programme, or to apply for EIF support, please visit our Expressions of Interest page.