European Private Credit: A Permanent Place in the Toolkit

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Over the past two years, private credit has gone from a supporting role to a starring role in financing transactions such as leveraged buyouts, bolt-on acquisitions, and refinancings. The share of transactions financed by private credit in European markets more than doubled between 2020 and 2023, from 27% to 56% (Exhibit 1). 

EXHIBIT 1: Private Credit has Continued to Take Market Share from the Syndicated Market in Europe

This image is a bar chart showing the percentage of market share that private credit has taken from the syndicated market in Europe from 2014 through 2023.
Source: ION Analytics and PitchBook LCD as of December 31, 2023

Of course, that’s partly because investors had no choice. Broadly syndicated markets were largely shut and are just now starting to reopen. We doubt private credit can continue to finance nearly two-thirds of leveraged buyouts as the lower costs in syndicated markets lure larger issuers back.

Yet, syndicated markets reopening is not a bad thing for private credit. Private lenders need functional capital markets to help grease the wheels of the buyout industry, and we firmly believe that public and private credit markets are meant to coexist. Private credit has become a permanent tool in every market participant’s toolkit, offering two main advantages in our view: certainty of financing and flexible structures.

Going for the Sure Thing

One of the reasons borrowers sometimes choose the private markets is for the reassurance of knowing that their financing will come through at a certain price.

Direct lending is often used by prospective buyers who wish to bid for a company at a competitive auction. Bidders who seek funding in leveraged loan or high yield bond markets in these situations typically go to an investment bank to underwrite and distribute debt. The cost of an investment bank-arranged financing remains unknown until the distribution is complete. Three years ago, the chance of receiving a nasty surprise at the end of the distribution was lower because financial markets were stable. However, after a period that included every kind of volatility (not least for interest rates), the chance of an unpleasant surprise in today’s environment is significantly higher, in our view.

Flexible Structures

Another reason people may choose to borrow in private markets is the ability to create bespoke structures.

Much of the lending that we do finances private equity transactions. Given the higher rate environment, leverage alone cannot make a successful transaction. Indeed, we at KKR have never subscribed to the use of leverage itself as being the primary driver of returns; instead, we are more driven by value creation and operational improvement, as well as strategic M&A.

Direct loans can be structured in a way that they support a borrower’s plan to create value. Examples include additional delayed-draw aspects to support tuck-in acquisitions, deferring interest in order to preserve cash and thereby allow the company to invest more of its operating cash flow in growth, and (sometimes) better matching the currency profile of borrowers than syndicated solutions.

Outlook for European Credit

We see the European financial markets in general as supportive for lenders and believe they are stabilizing. Economic growth is slow, but expanding, and we expect transaction momentum to build ahead of European Central Bank rate cuts later in the year.

Supporting this view, private equity sponsors are sitting on a record $2.5 trillion dry powder globally that they will almost certainly put to work (Exhibit 2). The global direct lending market is currently only $700 billion, so clearly it cannot come close to being able to finance all the buyout activity this dry powder might drive. We expect a wave of new transactions and that should boost activity in both syndicated and direct loan markets.

EXHIBIT 2: Global Private Equity Dry Powder

This image is a bar chart showing the record level of private equity dry powder across the U.S., Asia and Europe.
Source: Preqin as of December 31, 2023. Past performance is no guarantee of future results.

Meanwhile, some market participants have questioned whether the record high spreads and total returns of 2023 are sustainable when syndicated markets reopen fully. They are not. We expect to see some tightening in margins as well as a decline in total returns as central banks start to cut interest rates.  Rather than thinking about absolute returns in direct lending, we encourage investors to think of it as an all-weather, floating-rate product which, on average through market cycles, should generate an effective spread of between 650 and 700 basis points above reference rates, after accounting for contractual margins, amortized fees, and typical loan durations. We think this is a sustainable rate, so long as private lending offers the kind of flexibility and certainty that borrowers continue to value. Direct lending is not likely to be the preferred source of funding for the majority of buyouts going forward, but we feel confident that its role in the corporate financing toolkit is secure (Exhibit 3).

EXHIBIT 3: A Permanent Place for Direct Lending in the Corporate Funding Toolkit

This image is of a toolkit labelled as “European Direct Lending”. The tools represent the following: financing certainty, flexible structures, and a strong relationship between debtor and creditor.
  1. Credit