By James Williams – “Now is a good time to be a direct lending manager. We view what’s happening in Europe as a secular shift in the structure of its market. Whereas it was once 90 per cent dominated by banks, increasing institutional capital is beginning to balance things up,” comments Mike Dennis (pictured), managing director and co-head of Ares Capital Europe LP (ACE).
ACE is the European private debt lending arm of US firm Ares Management, a USD56billion alternative asset manager specialising in credit.
Quite how far European institutions will penetrate the capital markets remains to be seen. It’s unlikely that Europe will end up like the US, where approximately 80 per cent of capital is institutional, but Dennis is adamant it will play an increasingly important role: “The shift has only really just started.”
To provide some context, in Europe the direct lending capabilities of private equity and hedge funds is estimated to be around EUR3.5billion, Jeremy Ghose, head of buyout firm 3i’s debt management unit, told Reuters. By comparison, the banks held EUR4.7trillion of outstanding loans at the end of 2011, according to the ECB.
But change, however insubstantial, is certainly afoot. Ares Capital Europe is in the process of closing its second fund this quarter, and has a long-term plan to launch more funds thereafter. Just last month, Legal & General announced a GBP120million 10-year debt facility to Bruntwood, a UK commercial property company. This is Legal & General’s second real estate financing deal, following the GBP121million loan issued to UNITE Group in April 2012.
“We want institutions to play a bigger part in the direct lending market going forward. A small number of institutions won’t provide the depth of liquidity required long term, so we are encouraged to see more firms entering the direct lending space. You can’t do it with a handful of players as the liquidity won’t be deep enough. Intermediate Capital Group are currently trying to raise a senior loan fund so it’ll be interesting to see how they do,” says Dennis.
Ares Capital Europe: A European vanguard
Ares Management LLC, headquartered in Los Angeles, was established in the late 1990s. It currently runs the largest Business Development Company (BDC) in America, Ares Capital Corporation: a USD6.3bn Nasdaq-listed specialty finance company providing debt financing to approximately 153 US middle-market companies.
In 2007, Ares decided to extend its direct lending expertise into Europe. The firm already had a European presence, having established a CLO business in 2006. However, unlike the US, its European vehicle – Ares Capital Europe Ltd – is only open to private investors.
Explains Dennis: “The public markets in Europe aren’t yet ready for listed direct lending vehicles. We raise private money from investors – sovereign wealth funds, pension funds, insurance companies, etc. We have offices in London, Paris, Frankfurt and Stockholm and have around 25 dedicated professionals. We were one of the first direct lending private debt funds to launch in Europe.”
Since 2007, ACE has managed to put EUR1.5billion of capital to work and is invested in more than 50 European middle-market companies. The strategy, in essence, is to originate loans and lend to companies with an EBITDA of between EUR5million and EUR75million. It provides a mixture of senior, unitranche and mezzanine debt to help companies fund leveraged buyout activity, refinance themselves or help achieve growth targets. To clarify, unitranche debt combines senior and subordinated debt in one instrument and is often used for LBO purposes.
Dennis says that typically each loan has a five- to six-year maturity. Their size varies anywhere between EUR25million and EUR200million. The fact that the portfolio of loans held in ACE is so diversified is, in Dennis’s view, one of the firm’s core competitive advantages:
“What we say to investors is that if you manage your strategy across the balance sheet – that is you invest in senior debt, unitranche debt and mezzanine debt – in a blended strategy, we fundamentally believe you can deliver 10 to 12 per cent unlevered net returns each year. Compared to current returns available from fixed income and/or equity on a risk-adjusted basis, that’s pretty attractive.”
Not only is the portfolio geographically diverse (50/50 split between UK and Europe) but sector diverse. Add in that each tranche of debt works out to be roughly 33 per cent of the portfolio, and the fund has just as familiar a construction as a standard bond fund; but with the benefit of added yield.
The first fund was more of an evergreen fund than a typical GP/LP structure, and could have continued to raise capital, but Dennis points out that the firm had reached a point in its development where it made sense to launch a second fund: one that will, in fact, use a GP/LP structure.
And the reason for launching is simple: investor interest in direct lending is building.
“The capital raising exercise has been really successful so far, we’ve really expanded the LP base. The level of interest in private debt and direct lending is significant. Given that we’ve already invested EUR1.5billion over the last four years in the first fund, we’ll be expecting something similar in this second fund. There’s certainly been a re-balancing of allocations to credit and direct lending strategies have benefited,” says Dennis.
The name of the second fund is Ares Capital Europe II.
There are other reasons, aside from attractive risk-adjusted returns, for why investors are beginning to favour direct lending funds. Firstly, it helps that ACE’s investment strategy is to lend first and second lien senior debt i.e. at the top of the capital structure, where risk is that much lower.
Then there’s the overall approach to investing. For a firm like ACE, this is very much a long-term business. They’re in it for the long haul. This reassures both the companies they lend to and their investors.
“LPs ask us “Is this just a short term opportunity given the current market dislocation?” That is, raise a fund, invest in it for a couple of years and then move on to a different strategy. Well, if we’re lending money to a company over a four-, five-year period we can’t just pack up our bags within a couple of years because we’ve made the returns we were looking for. That would be counter-productive for us as a business.
“For distressed debt strategies buying secondary market assets, I think that is a tactical two- to three-year trade. But in terms of establishing an institutional lending business as Ares has, this is a long-term strategy and one that will see us continue to launch funds going forward,” asserts Dennis.
Trust is a huge part of direct lending. After all, most companies are used to dealing with banks to get their loan arrangements, not third party asset managers. Once a deal is arranged, it sets the tone for a strong ongoing relationship between the manager and the firm. Getting it right from the outset is crucial.
“At the beginning we had to ensure that companies trusted us. It helps that a lot of our team are ex-bankers. Our whole approach is to originate the deal, execute the transaction, and then manage the portfolio. We’re there from start to finish, and this helps foster trust. This is absolutely a relationship play,” says Dennis.
Aside from relationship building, any serious direct lending firm needs to have sufficient “skin in the game”. That’s why firms like ACE, International Capital Group and others have invested heavily in their infrastructure. It takes time and commitment – attributes that any institutional investor would take succour from.
A great deal of emphasis is placed on rigorous due diligence when selecting the right companies in which to invest. In this regard, ACE is in a favourable position. The Ares platform, with USD56billion in assets, has relationships with around 1,500 companies globally. In Europe, this is a huge advantage when performing due diligence on a target company, with Dennis noting that “it is uncommon for us to have no platform knowledge of the company, or the sector in which it operates”.
“We take a forensic approach to due diligence to ensure we’re lending to the right companies. Credit is quite an asymmetric asset class in that if you get it right, you’ll earn, for example, 10 per cent annualised, but get it wrong and you could end up losing money. To be successful you have to have a thorough due diligence process, which we do,” explains Dennis, adding:
“Unlike banks, which take a cookie cutter approach to loan origination, we assess the risk of a company on a case by case basis. The debt structure and pricing that we put in place is very specific to the risks we identify in that company. In the banking market you’ve got a pretty tight band of pricing for companies. We don’t tend to follow those rules. We price the individual risk of every company we lend to.”
The whole focus of Ares Capital Europe Ltd, and indeed the imminent second fund, is to invest purely in performing companies.
“There are direct lending strategies out there that focus on special situations, distressed debt. But Ares Capital Europe is very much a performing loan strategy.”
If Dennis’s expectations of more institutional players entering this space are realised, direct lending in Europe could be on the cusp of something much bigger. For institutional investors looking for diversified strategies, that’s an exciting prospect.