The Rising Role of Private Credit in European Financing: A New Dawn of Opportunities

In an evolving global financial landscape marked by tightening regulatory conditions, the real prospects of recession, and the continued retreat of traditional banks, private credit has carved a niche for itself, particularly in Europe. Here, Small and Medium Enterprises (SMEs), professional real estate developers, and the corporate credit sector are finding in private credit firms, like Arrow, a reliable alternative to conventional banking systems. As banks retrench, they leave behind a critical lending need which is being filled by private credit entities.

Historically, banks have been the linchpins of the lending ecosystem, a status quo unchallenged until recent years. New conditions have disrupted this stability, such as the potential for heightened capital requirements and the ongoing banking crisis affecting major players like First Republic, Signature Bank, and Silicon Valley Bank in the US, and Credit Suisse and UBS in Europe. These recent pressures have made lending more burdensome for banks, constraining their ability to meet the credit needs of businesses and individuals.

Simultaneously, these same conditions have given rise to an advantageous position for asset managers with capital ready to deploy. Untethered by the regulatory restrictions that traditional banks face, these players are advantageously placed to capture significant market share in the credit space.

Prominent asset managers have exemplified this potential by leveraging the opportunities created by the shifting tides. Unburdened by the traditional banking constraints, private lenders are demonstrating resilience and adaptability. One notable player, for instance, recently secured €650 million in direct lender financing for its acquisition of one of the world’s leading providers of services for the industrial and aerospace and defence markets. Similarly, Arrow-affiliated Maslow Capital hit a new milestone by lending over £400 million to UK real estate developers in Q1 2023 alone. These two examples alone serve to highlight the burgeoning role of private credit within the financial ecosystem. Our recent fundraise of Arrow Credit Opportunities II (‘ACO II’) fund, which reached hard cap of €2.75 billion in under eight months, with almost unanimous re-up from ACO I investors, is indicative of extensive investor demand for the right partner and investment strategy.

These instances, far from being outliers, are now becoming commonplace as private credit firms rise to meet the demand left by traditional banks. The dislocation in the syndicated loan market has created a vacuum for private credit firms to step in and provide replacement capital where banks are increasingly hesitant, and to buy up secondary positions.

So why this reluctance from banks? Several factors contribute to this shift in the European landscape. Following the Global Financial Crisis in 2008, banks have been subjected to more stringent regulations, such as Basel III and IV, making lending less attractive. The historically low-interest rates maintained by the European Central Bank have also put a squeeze on banks’ profits, diminishing the appeal of lending. Coupled with this, the high levels of non-performing loans (NPLs) are tying up capital and increasing the cost of lending, forcing banks to be more cautious. Additionally, the advent of FinTech companies and digital banking platforms like LendInvest in the UK and Spotcap in Germany is shaking up the traditional banking landscape, while economic uncertainties like Brexit, trade tensions, and the pandemic fallout have forced banks into more conservative lending stances.

However, every challenge brings with it an opportunity. The shift towards private credit is indeed reshaping the financial landscape in a significant way, and it’s a testament to the adaptability of our financial systems. Private debt assets under management (AUM) are forecasted to grow at a Compound Annual Growth Rate (CAGR) of 10.8% between 2021 and 2027 to reach an all-time high of $2.3tn in 2027, a significant increase from the 2021 figure of $1.2tn (Preqin October 2022). Compared to all alternative assets AUM growing at 9.3% CAGR over the same period, private debt is gaining share overall.

Investors with ‘dry powder’ to deploy are keenly seeking better yields in the current low-interest-rate environment. Private credit offers a compelling alternative and as a result, more capital is flowing into this space. The promising risk-adjusted returns of private credit continue to attract investors with nearly two-thirds saying they plan to increase allocations over the long term, the highest since 2016 (Preqin June 2023). In particular, direct lending, which accounted for the largest strategy in private debt at 44% in 2021, is predicted to increase its share of Assets Under Management (AUM) to 54% by 2027 (Preqin October 2022). Its strong returns are compelling for investors seeking to preserve purchasing power, particularly when compared with publicly traded instruments where investors have less control over lending conditions and covenants.

Moreover, there’s an increasing appreciation for the importance of ESG considerations in the investment process. Regulations like such as the EU’s Sustainable Financial Disclosure Regulations (SFDR) and memberships like the UN’s Principles for Responsible Investment (PRI) or the Global Real Estate Sustainability Benchmark (GRESB) have underscored the necessity of incorporating ESG factors into investment decision-making and portfolio management processes. Furthermore, aligning investment strategies to initiatives like the UN Sustainable Development Goals (SDG’s) allows for firms to recognise where they can have the greatest impact and incorporate ESG as a core strategic pillar across the firm. As private credit firms embrace these regulations and reporting frameworks, they will be better positioned to meet the growing demand for sustainable and responsible investments.

In conclusion, the rise of private credit as a significant player in European financing shows no signs of abating. Cycle-tested managers equipped with local knowledge, operational acumen, and a commitment to ESG considerations are well placed to unlock value from their portfolios, helping to bridge the critical return gap. In a climate where public equities and bond markets continue to see compression, the gravitational pull of private credit is likely to grow ever stronger, helping to provide a viable financing alternative, and contributing towards a more sustainable financial future.

Reference:

Preqin (October 2022) Preqin Special Report: The Future of Alternatives in 2027

Preqin (June 2023) Preqin Investor Outlook: Alternative Assets, H1 2023