Banks battle back with their own fund launches

Q1 2021

Feature

Michelle D’Souza

Reporter Creditflux

Karis Hustad

Reporter Debtwire

Through their own direct lending arms, large banks are leveraging their long-standing expertise and offering private debt to reclaim market share. Though small now, these hybrid bank funds are certain to grow

After years of finding themselves increasingly disintermediated by direct lenders, banks are now raising their own direct lending arms. Several have gone down that route, and more are following to maintain market share and make themselves more relevant.

Investec and HSBC are two of the latest to jump on the bandwagon. The former amassed €165 million on a first close for its inaugural Investec Private Debt Fund I in Q1. The strategy invests across the capital structure, including senior secured debt, unitranche and subordinated debt, for PE- and corporate-backed companies between €3 million-€75 million EBITDA. It will primarily focus on investments in the UK, Ireland, Benelux and DACH regions.

HSBC also unveiled a UK private debt fund with its asset manager affiliate HSBC AM, which focuses on companies between £5 million-£50 million EBITDA. The pair have an exclusive partnership, with HSBC bank acting as lead originator on senior secured loans to middle market PE-backed companies in the UK. HSBC AM will choose the loans.

These funds are typically focused on sub-€100-million-type financing, specifically in deals with lower levels of leverage, generally paying less than unitranches, and have less-aggressive terms.

Callum Bell, head of lending for growth and leveraged finance at Investec, says the market is quite simplified in bucketing lenders — either bank, club or fund.

“We see the debt market more holistically than that and start from the borrower needs first and a product second — i.e., what are the borrower needs and how can we solve this across the capital structure?” says Bell. “We look to structure flexible lending solutions not constrained by product norms that tailor to the borrower needs across the yield spectrum from 3% to 10%+ … Augmenting our balance sheet by raising third-party capital became essential to do that effectively.”

Peter Bate, head of leveraged finance and M&A debt at KPMG Debt Advisory, agrees and says it is not about banks wrestling back control, but rather a complementary scenario to fill a gap in the market.

“It bridges a situation we see frequently in the market — we may be looking for a £30 million package, say, around 3/3.5 times leverage with a possible need for follow-on capital. Realistically, two banks are needed to carry out that deal, and if you add follow-on capital and capex lines, possibly three banks,” he says.

“Many borrowers may say it’s too hard to work with three banks and would prefer to go with a unitranche provider. But rather than 3%-4%, the margin jumps to around 7% for unitranche deals — that’s a big bridge to negate the fact you need a couple of banks.”

Together with stretch senior products, these new bank funds could bring structure around that, Bate says, and it provides optionality for clients and borrowers.

For now, these new bank-affiliated funds appear to target a small, specific niche of the direct lending space and are not in direct competition with many of the larger mid-market European private debt managers, sources say.

Stuart Hawkins, managing director at Ardian Private Debt, says he sees the trend as an extension of a bank’s capability to do senior debt loans where, for example, a deal for €50 million of funding would have otherwise required multiple banks, rather than encroaching on mainstream private debt deals.

Hawkins adds that these funds appear to be more of a competitor to other banks than to funds. “When we write, say, a €50 million cheque, our counterparty is often interested in whether we can scale this to €100 million or more over the course of the investment period,” he says. “The headlines regarding these bank-affiliated funds appear to be smaller-sized funds, which as it stands today don’t look like they can absorb that scale.”

Antoine Josserand, head of business development and investor relations at Pemberton, says: “We have a senior loan strategy which does address the traditional segment of bank club deals — lower-levered type of transactions levered around 3.5 times. These banks’ funds are relatively constrained in their allocation at the moment, whereas we can provide certainty of execution for the entirety of the transaction to our bank and sponsor partners.”

Despite the ability to hold a larger amount, banks may find themselves constrained by the issues that have always plagued the banking market, namely their inability to act fast, says a direct lender. “You can’t eliminate the fact they are operating within a large bank, which comes with some of the baggage around decision-making,” he says.

But that does not mean these new bank funds do not have bigger ambitions. Bell says he plans to build out the business to over £1 billion in the next five years to deliver this strategy. He also points out that banks have a history that the relatively new debt funds cannot compete with.

“What the LPs wanted was to buy into a track record and the people that have delivered it,” says Bell. “We were a first-time fundraise, but we’ve been together as a team for 10 years, have lent well over £5 billion in that time and have built an enviable track record of risk-adjusted returns against de-minimis losses. That counts for something when LPs are looking to invest in you. They are buying into a 10-year track record and a lending philosophy, if you like, the fund has just been the balance sheet. So, we’re externalising that track record.”

As the strategy is an attractive proposition for banks to maintain market share, and as fund sizes could grow, it will be interesting to see how debt funds respond.

Banks vs funds: the history

The issue banks are addressing is not a new one, says Philip Butler, partner at Dechert. Historically, this sub-€100-million-type financing would have been part of the bank club market with market participants such as HSBC, RBS and Lloyds clubbing together and taking €25 million each, he says.

But for more than a decade, debt funds have swooped in and picked at deal flow, with the ability to take down the entire €100 million piece — an attractive option for sponsors in a competitive market with quicker transactions, one party and more flexible terms.

This occurred at the same time that banks continued to retreat from the leveraged market generally following the financial crisis given its higher capital weighting and particularly from more aggressive terms. However, unitranche financings attract a higher coupon for borrowers, which was not perceived as the right price for more conservatively structured deals. A gap emerged in the market for these lower-levered deals.

To overcome this obstacle, some banks formed partnerships and tie-ups with pension funds and insurance companies. In a €100 million deal, for example, €25 million would sit on the bank’s balance sheet while institutional investors took €75 million. Partnerships included NatWest with AIG, Hermes and M&G; Lloyds with Canadian pension fund Aimco.

“These partnerships were reasonably successful,” says London-based Butler. “Pension and insurance funds were hungry for yield and the 4%-5% on pricing offered attractive returns.”

Debt funds also began to raise capital for such deals in the form of managed accounts, which sat alongside their flagship funds.

“Where there’s a will, there’s a way,” Butler says. “A number of funds had access to the money to do these types of deals on a one-stop-shop basis, but it’s not their bread and butter. Returns on these are a lot lower than typical unitranche type financing and only for a certain type of deal.”

The mid- and large-cap precursors

Some banks have long been contenders in the upper mid-market and large-cap direct lending space. Goldman Sachs has been making direct lending investments since 1996, first via mezzanine funds and more recently through senior secured funds — recently providing a €300m unitranche to back the buyout of IAD in France, for example. In September 2020, Credit Suisse announced it would team up with the Qatar Investment Authority to form a multibillion-dollar direct lending platform providing primarily first and second lien loans to upper mid-market and large-cap companies in the US and Europe.

James Reynolds, head of the European Private Credit Group at Goldman Sachs, says the benefit of working with a lender with the scale of their institution is the ability to combine the speed of direct lending with the other services, such as multicurrency transactions, expansion to other geographies and wealth management.

“If you speak to management teams, they welcome the idea of just having one or a small club of direct lenders,” says Reynolds. “We’ve also received a lot of comments from CEOs and CFOs delighted to be associated with what we can bring as a firm beyond capital only. We also use this to differentiate ourselves — we bring more than capital.”

Ultimately, there is a sense that innovation is the only way forward in such a competitive market.

“Banks are becoming less relevant in certain parts of the market. That is a fact,” Bell adds. “Some banks will be slow to adapt and see their market share continue to fall. Others will innovate, change and adapt and we see ourselves as leaders in that camp and have been over several years.

“The long-term strategy is to be a leader in providing debt solutions to the European mid-market, not the best bank nor the best fund, the go-to lending franchise for our mid-market sponsors and corporates,” he adds. “More of a bank and fund hybrid — a ‘bund’ if you like. We believe strongly that building out our third-party capital is a critical component to deliver that ambition.”

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