A Warning for Small and Medium Enterprises in Europe

(Bloomberg) -- Some of Europe’s most aggressive private lenders risk trapping companies in a low growth limbo, a move that would jeopardize the region’s recovery, according to the head of private debt at the international business of Federated Hermes.

Patrick Marshall expects the direct lenders who have come to dominate the loan market for small and medium-sized companies to lose out to banks amid a flight to safety in the aftermath of the Covid-19 pandemic.

Still, he doesn’t anticipate they’ll go quietly. Instead, he forecasts that managers and sponsors will strike a “Faustian” pact to keep hold of their existing borrowers. That could end up locking inviable businesses into a low-growth cycle, while crowding out new entrants and ultimately leaving investors with lower recoveries from deals gone wrong.

“One of the prime risks we’re going to see with this crisis is the rise of the zombie SME in Europe,” he said. “By that I mean the Japanification of European SMEs.”

Federated Hermes has around 513 billion euros ($564 billion) of assets under management.

Europe’s direct lending market grew from $1.5 billion in assets in 2009 to $120 billion in mid-2019, according to data provider Preqin. Deloitte has tracked deals by non-bank lenders in Europe since late 2012 with 2,272 such loans executed as of the end of December. The deal count rose 13% year-on-year in 2019, according to Deloitte.

But Marshall expects that banks will now regain their edge as the main provider of loans to mid-sized companies as M&A deals dry up and investors realize the true risks of extending large-cap style loans to mid-sized businesses.

“There’s going to be reduced M&A, so it’s going to push people to lend to corporates rather than just sponsors,” he said. “There’s going to be more plain vanilla structures in lending.”

Unitranche Loans

The strategies of direct lending funds vary but the bulk focus on so-called unitranche loans, which mix together safer and riskier debt, allowing private credit funds to lend -- and charge -- more than banks.

But the pandemic crisis has forced investors to face a simple fact: unitranche loans do not have the first claims over a borrower when it comes to paying back debt, Marshall said.

The businesses tapping unitranche lenders finance themselves day-to-day with cheaper working capital lines from banks who have established a market standard putting their smaller ‘super senior’ revolving credit facilities (RCFs) ahead of the unitranche debt.

That’s a key difference with other senior secured loans, which rank the same as the RCF, Marshall said. Hermes’ own direct lending fund mostly invests in deals alongside banks and their loans rank the same as the working capital, he said.

It’s those RCFs that companies are drawing on in their droves to stay afloat through the shut-down.

“The unitranche lenders are going to have to answer how they make themselves relevant if they are going to compete for the best credits,” Marshall said.

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