That it has been a comparatively tough few years for private equity is news to nobody. The rate-hiking cycle of 2022-23 has dampened M&A activity, impacted PE managers’ return expectations and prompted LPs to review their allocations to the asset class.  

These developments have raised interesting questions for private credit. On the one hand, the same higher-interest-rate environment had prompted talk of a ‘golden age’ of private credit. On the other, the alternative lending market is widely perceived to be dependent, in large part, on strong PE-led M&A activity for its own deployment, as well as the return, of capital.  

Last week, Hayfin attended IPEM, one of the leading European conferences on private markets, in Paris. The official theme of ‘Forging Confidence’ reflected the sense of cautious optimism towards tentative signs of an early-stage recovery in deal volumes. The event provided us and our peers with a chance to reflect on the unusual environment of the past few years and what this means for private credit going forward.  

Newcomers find European private credit a tough nut to crack  

There has been a notable change in the mood music between last summer’s flagship private market conferences and the conversations taking place last week with regard to competitive dynamics in private credit. 

Last year, many investors and managers were suggesting that the market was about to be shaken up by a flurry of new managers. Both alternative investment firms and traditional asset managers were expected to pile into the asset class. 

That sentiment has now been turned on its head. A number of the newer entrants to the asset class are reportedly either reevaluating their private credit strategies or scaling back their operations entirely.  Subdued M&A activity and, by extension, direct lending volumes have been felt more sensitively by alternative credit providers who do not have an established presence and are looking to break into the market. 

The concentration of activity among a relatively small number of participants has been a longstanding feature of the European private credit market. The top 25 private credit funds in Europe have accounted for up to three-quarters of the total capital raised since 2007. By contrast, in the US, the top 25 funds account for approximately half of total fundraising, there is a long tail of smaller funds that hold a large pool of capital and can better compete with their larger peers on deal sourcing.  

In the European market, in other words, capital and investment opportunities accrue to the top 25 largest private credit funds, with the Direct Lending market in which we operate having 10 or fewer direct competitors.    

Advantages of incumbency laid bare 

The lingering uncertainty about the global macroeconomic environment, as well as the mismatch in valuation expectations between the buy-side and sell-side, all of which served to suppress transaction activity over the last couple of years, has begun to abate. We are seeing greater convergence on valuations and growing confidence that, if sponsors bring the right assets to the market, they are less likely to falter during the sale process.  

However, it remains difficult to assess when M&A activity will reach the top of its cycle again. It’s quite likely that a higher-interest-rate environment will remain a drag on a fully fledged rebound.  

Private credit firms that are less heavily reliant on an opportunity set defined by the cyclical nature of M&A will therefore continue to enjoy an advantage in deploying capital over the years ahead.  

In truth, large parts of the market do depend on this cycle. Once again, the established players with incumbency advantage are best placed to access narrower PE-led processes when M&A activity is subdued, and sponsors revert their focus on bolt-ons for existing portfolio companies. For example, in recent years, our existing exposure to more than 80 borrowers across our Direct Lending portfolios has allowed us to continue sourcing significant volumes of deal flow in high-quality companies we know well. 

The ability to originate these preferred deals is particularly advantageous in an investment environment characterised by a growing bifurcation in credit quality. Lenders without a large and sophisticated deal origination network will risk being adversely selected and ending up with concentrated exposure to second-tier credits, such as businesses that are more exposed to cyclicality, with tighter margins or more likely to struggle in a recessionary environment due to being smaller. Those who have that capability and the incumbency advantage can access deals with lower leverage and better documentation protections than has been the norm in recent years, at pricing levels that make for highly attractive risk-adjusted returns. 

Return of the broadly syndicated loan market? 

Finally, the post-summer gathering at IPEM provided an opportunity to reflect on another widely predicted trend that has not materialised to the extent that many expected. 

The first half of 2024 witnessed the widely heralded return of the broadly syndicated loan market (BSL), offering many upper-mid-market borrowers another avenue for financing, often at tighter spreads and more flexible documentation. This drove speculation that private credit managers would need to cut margins to compete. 

Our view had always been that a portion of deals which were financed by private credit in 2022 and early 2023, when leveraged finance markets were effectively closed, would be refinanced back into the syndicated markets. However, we predicted that there would remain a still-large opportunity set of sponsors and businesses for whom the tightest possible pricing isn’t their sole concern. That could be mid-market businesses less likely to find a solution on syndicated markets, or large-cap sponsors investing in a challenging sector or pursuing a buy-and-build strategy which requires incremental capital.   

It has certainly become more important for private credit managers to demonstrate their ability to access attractive deal flow involving companies in sectors, size brackets or situations where the certainty, efficiency, flexibility and resilience offered by a direct lender outweigh the purely economic or documentary incentives to tap the BSL market. But we believe that the comparative deal volumes in the BSL and private credit markets are bearing out our assessment that there is a large and fast-growing white space not covered by syndicated markets, available at a risk-adjusted-return profile that meets LPs’ expectations.