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Direct Lending Emerges as Solution to Europe’s Great Deleveraging

The credit crunch is rapidly fading In the US, where non-bank sources of financing are plentiful and business borrowing is rising strongly. In December 2014, the Thomson Reuters/PayNet Small Business Lending Index rose to 129.8, the third-highest level in ten years.

But in Europe, where businesses are much more dependent on bank finance, the faucet of bank lending remains shut. Banks continue to take a very cautious approach to lending, particularly to SMES which, unlike large companies, cannot get alternative sources of financing from the bond and equity markets.

The banks argue that their hands are tied as the raft of regulations introduced to prevent a repeat of the recent financial crisis has obliged them to offload riskier assets. The “Great Deleveraging” seems set to continue for several years and the difficulties it creates for European SMEs could not come at a worse time.

As well as the timid economic recovery in Europe, which is fueling a growing demand for new credit, European SMEs have the additional headache that a large proportion of the credit raised in the boom years of the past decade is due to be refinanced by 2017.

With established capital markets apparently incapable of supplying this untapped demand for liquidity, specialist asset managers have jumped in to fill the gap, creating funds that lend directly to SMEs and so cutting out the banks. Traditional asset managers, too, are also taking an interest in direct lending to diversify their portfolios.

The direct-lending market is still young but growing rapidly. According to Standard & Poor’s more than €10bn was raised across 200 deals in Europe in 2014, compared to just €5bn a year earlier.

Direct lending has emerged primarily at a response to the unwillingness of banks to lend to SMEs. So investors in funds that specialize in direct lending need to be aware that if banks do start to open the faucet again, the direct-lending sector could be adversely affected.

Nevertheless, many observers believe that the direct-lending trend is not a temporary phenomenon and could instead become a permanent feature of Europe’s lending landscape. Indeed, European businesses that can raise finance from bank lending are also now looking at direct lending as part a diversification strategy.

That’s because the traditional alternatives to bank financing are much less developed in Europe than they are in the US. So, European SMEs have often had little realistic alternative to the banks when it comes to raising funds.

The advent of direct lending allows businesses to actively diversify their financing, reducing their dependence on a small number of banks whose long-term support is far from certain in the current climate.

Despite the short track record of direct lending, this new style of funding has proved popular with European businesses. According to a recent report on non-bank lending from Grant-Thornton, 79 percent of businesses interviewed rated non-bank lenders positively or very positively.

The ability for asset managers to raise large sums of capital from investors interested in this asset class makes direct-lending funds more attractive to business borrowers than other P2P funding initiatives.

In addition, the better established direct-lending funds can often support multiple funding rounds by the same borrower. That provides businesses with greater certainty and long-term support in an era when banks are less willing to take the long view.

Institutional investors have warmed rapidly to direct lending, attracted by the risk-adjusted returns and the straightforward nature of the investment. Clearly, the risk profile of direct-lending is higher, as SMEs have higher credit risk than large enterprises.

But asset managers try to minimize the risk using their local knowledge to identify good businesses across Europe that are profitable and cash-generative and so well-suited to building a long-term lending relationship.

Technology also plays a key role and ClearStructure, with more than ten years of experience addressing the specialist needs of loan trading clients, is well placed to capitalize on the direct lending trend.

The Loan Administration, Performance and Portfolio Management modules in ClearStructure’s Sentry platform already meet the needs of firms entering this new market.

As the Great Deleveraging continues to impact Europe’s economy, direct lending has emerged as a market-based solution that appeals to both investors and borrowers alike.