Once upon a time, it was more straightforward. As a general rule, banks lent money to businesses while funds invested in them.
Then came the global financial crisis in 2008, and the tighter regulation of the banking sector that followed. One consequence of those new rules was an increase in the cost of capital for banks carrying loans to riskier, sub-investment grade borrowers. For the banks, this meant lower returns, or more expensive debt.
As a result, banks have been pulling back from that market, with their place taken by the less-regulated private credit providers – or direct lenders as they are otherwise known. In Europe, these are mostly credit funds.
Over the intervening years, direct lenders have played a major role in supporting the expansion of the European leveraged loan market by providing debt capacity to private equity investors. Low interest rates and high investor returns, among other factors, have seen the European leveraged loan market almost double in size from December 2012 to October 2022, to nearly €300bn.
There are some areas, however, where banks remain the primary actors. Revolving facilities, often used to provide working capital lines, are not something that many funds, in particular, can efficiently provide. Similarly, funds are not generally set up to provide other general banking services, such as treasury management, derivatives and foreign exchange, or letters of credit.
But this change has by no means been limited to the provision of sub-investment grade debt for leveraged finance transactions. Credit funds are increasingly active in many other areas of the market such as infrastructure debt and real estate debt, to name just two. Indeed, only in June the Financial Times reported that direct lenders such as Apollo, Blackstone and KKR have now entered the investment grade market to provide an alternative source of liquidity to blue-chip companies.
Overall, the past 15 years have seen a proliferation of private credit. The returns to investors have driven fundraising success and, since 2012, the European private credit asset class has grown more than fivefold to $187bn in 2022.
All of this adds up to a picture of traditional bank lenders working alongside an expanding population of credit funds that have considerable amounts of undeployed capital to lend, while both provide funding solutions to clients across an ever-widening range of debt products.
There are some lessons to be learnt from the mid-cap leveraged finance market.
As private credit providers converge with incumbent bank providers in new markets, these new neighbours will find themselves looking to establish market norms as a guide to how they can get along and work out their own intercreditor relationships. Given the prevailing economic climate, the challenge inherent in those discussions may be compounded by the financial stress of borrowers.
One of the longest-established arenas for such collaboration is the mid-cap leveraged finance market. Here credit funds or other direct lenders now routinely provide a unitranche term loan on a senior basis, with a working capital line, typically structured as a revolving credit facility, provided by traditional bank lenders on a super senior basis.
This is an approach that delivers a more competitive overall financing cost to the borrower, while also meeting the different risk appetites of each creditor group.
Of course, each negotiation will be conducted on its own merits. But maybe there are some lessons to be learnt from the mid-cap leveraged finance market. The unitranche/super senior revolving credit facility structure essentially trades risk for control. The bank creditor takes the less risky position where, among other benefits, it enjoys a first-ranking claim on the proceeds of any enforcement of security ahead of the direct lender providing the unitranche loan.
In return, the unitranche provider has more control over creditor decisions, including around enforcement. The pricing of the two tranches of debt generally reflects this differential risk profile.
But it also does more than that. The “neighbours get along” because this structure recognises the broader strengths and capabilities of both creditors, while the composite solution as a whole delivers value to the borrower. The bank creditor is delivering revolving credit, and possibly other treasury management and ancillary lines that its platform can readily provide, and all with an acceptable risk/reward profile.
The direct lender, by contrast, is providing term debt that its structure can easily accommodate and with a higher risk/reward profile that is more suited to the requirements of its own investor base.
Furthermore, with control of most creditor decisions through the life of the credit in the hands of the direct lender, the borrower, and its private equity sponsor, will probably find themselves more frequently in discussions with a creditor who is likely to espouse a more similar private equity-style approach than that of a traditional lender.
This can facilitate discussions around key decisions such as implementing a buy-and-build strategy. Indeed, many credit funds have sister funds whose strategies focus on equity investment. Meanwhile, the super senior bank lender can draw comfort from the knowledge that the unitranche lender can only protect its own credit by first ensuring the bank’s credit is safeguarded.
In its conception, at least, it holds together like a Chinese luban lock puzzle.
Nonetheless, the current challenging economic climate will see some of these structures tested as never before, but it will also present new opportunities for such collaboration. So maybe there is some guidance here for how other “neighbourly relations” can be forged and managed as the boundaries of public and private credit shift, whatever the climate.
As long as they do, a more holistic awareness of each creditor group, their strengths and capabilities, and what they can bring to the benefit of both the borrower and the capital structure as a whole, might not be a bad place to start.
James Collis is a partner at law firm Norton Rose Fulbright LLP.
