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Private Markets 360° | Episode 17: European Credit Opportunities (with Christophe Rust, Co-head of European Credit Opportunities at Ninety One)

Jocelyn Lewis

I'll start off with introductions. I'm Jocelyn Lewis, Head of Private Commercial Strategy.

Chris Sparenberg

I'm Jocelyn's co-host, Chris Sparenberg, Head of Private Markets Commercial Strategy. I'm a super fan of our corner of the industry. My background includes time at Cambridge Associates on the monitoring and benchmarking team. As well as roles in go-to-market firms like eVestment Nasdaq and Juniper Square. I'm excited to be joining the podcast. We're thrilled to bring our listeners exciting guests every month for discussions about industry trends and other topics of interest here on the podcast.

Jocelyn Lewis

You sure are Chris and if you're interested in regular private markets content, hit subscribe and tune in. Ready to introduce our guests Chris?

Chris Sparenberg

Let's do it. Today, we have the privilege of speaking with a remarkable leader in the field of European credit opportunities. Joining us is Christophe Rust, the Co-Head of European Credit Opportunities at Ninety One. With decades of experience and a proven track record of success, Christophe is at the forefront of navigating the complex landscape of credit markets.

He brings a wealth of knowledge and unique perspective on identifying and capitalizing on credit opportunities across Europe. In this episode, we'll explore his journey throughout the world of finance, the challenges and the opportunities he sees in today's market as well as his vision for the future of European credit. Christophe, thank you for joining us today, and welcome to Private Markets 360. How are you?

Christophe Rust

Very well. Thank you, Chris. It's a pleasure to be speaking with you today.

Jocelyn Lewis

Well, thank you, Christophe. It's so great to have you on the podcast. And to kick off our discussion, we'd love to hear why you find this area of credit particularly appealing in the current market environment.

Christophe Rust

Absolutely. Ninety One is a global asset manager that was founded in South Africa in 1991 and has grown since then into a global business with about $150 billion of assets under management. And my partner, Lei Lei and I previously worked together very closely at a credit manager named Oak Hill Advisors before joining Ninety One. About 3.5 years ago, there's a large universe of performing, so-called non-sponsored middle market borrowers in Europe that are being underserved by traditional sources of financing.

And therefore, there is a funding gap that these borrowers face. Specifically, what we are referencing in saying this is the fact that these borrowers, which typically have earnings between EUR 5 million and EUR 20 million per year, and range in enterprise values from roughly EUR 50 million to EUR 200 million are typically too small to access the capital markets because they are not owned by a private equity fund or other kind of financial sponsor.

Jocelyn Lewis

So in the realm of non-sponsored lending, there's often a misconception that inherently it carries more risk compared to sponsored lending. And maybe that's partially true given that you mentioned your loans are generally more customized and therefore, more expensive. But could you shed some light on the market opportunities with the non-sponsored lending that you've identified and how you're able to navigate and mitigate those perceived risks associated with this segment?

Christophe Rust

Firms that are owned by private equity funds are more likely to grow and be well managed because their owners are very sophisticated and savvy financial investors. Now we wouldn't dispute that there are merits of a private equity firm owning a borrower.

This being said, we have a few thoughts on the matter that we think are quite interesting. And one of those is to note that the fact that a business is owned by a private equity fund by no means ensures that a loan to it will perform.

Indeed, history is, of course, littered with many private equity investments not having been successful. Ultimately, it's a much more nuanced picture. What matters is not -- whether or not a borrower is owned by a private equity fund, but fundamentally, how good a business, how good a credit that borrower is.

The second reflection we would share is that in order to successfully lend to non-sponsored borrowers, whoever is doing that lending, i.e., the manager, in this case, us, ought to have a specialized set of skills that include, but is not limited to good private credit skills.

Indeed, we are of the view that what's essential to lend successfully to non-sponsored borrowers is that the manager also has a good private equity toolkit and a workout skills toolkit. And the reason for which we think that is needed is that in the absence of a financial sponsor behind these borrowers, it falls upon us to perform the roles of the private equity managers, which is to say the upfront deep dive private equity style underwriting, but also to manage a loan in the event a borrower doesn't perform.

And if a borrower is owned by a private equity firm, the private equity manager will take the lead on both of those work streams. If that is not the case that there is a private equity sponsor, somebody has to do it, and it's got to be the lender.

So if the lender or manager has that set of specialized skills, then we are the view that lending to non-sponsored borrowers is not only less risky than lending to sponsored borrowers, we would actually go so far as to say it can be less risky rather than more risky, starting with the fact that oftentimes, the leverage when lending to non-sponsored borrowers is lower than the leverage of loans to private equity funds.

Indeed, the private equity funds look to maximize leverage because that's what helps drive the returns, whereas our loans have leverage ratios oftentimes of, say, 3x or 2.5x or 3.5x, and that might be more like 5.5x or 6x for a loan to a sponsored borrower. Secondly, our loan documents benefit from multiple forms of lender protections, such as multiple financial covenants. Oftentimes, loans to sponsored borrowers have one or no financial maintenance covenants.

And that's, by the way, because there is so much competition for providing such loans to sponsored borrowers. That is where the bulk of capital raise in the private credit market has come into, i.e., the direct lending market for sponsored borrowers, whereas by contrast, there is less competition in the market that lends to non-sponsored borrowers. That's so essential because that lack of competition is what allows for the enhanced terms, vis-a-vis a lender, but also the better pricing and risk return.

So to come back to the point I was making, our loans typically have 3 financial maintenance covenants that are tested quarterly. We also have a broad suite of undertakings to which the borrower is subject that limits the borrower in what it can do around additional indebtedness, granting of security, dividends, et cetera, basically anything that could materially adversely impact our position.

Jocelyn Lewis

When we think about the loans to these non-sponsored groups being inherently more customized and you're lending at a lower leverage multiple, but then you're still ultimately able to achieve really good returns, is that due to the fact -- are you structuring in any additional equity, even if it's minority equity or in the form of warrants enabled so that you're able to juice your returns?

Christophe Rust

There are a number of strategies out there that do aim to have that kind of equity upside. In our case, we may have some loans that benefit from some equity or equity-linked upside. However, in the main, the returns of our loans are derived from contractual income, which is to say typically some fees, so upfront fees, maybe some back-end fees and interest income.

So a typical loan, for instance, might be a 3-year loan to a German family-owned industrial business seeking growth financing. It's a business that has, say, EUR 10 million of EBITDA, then maybe he is looking for EUR 25 million of funding for 3 years.

And this loan of ours would have an interest rate equal to, say, 3 months Euribor because all our loans are floating rate loans. And then an interest margin of, say, 10%, for instance, of which a portion is payable in cash on a quarterly basis. And the remaining portion of that interest is not paid in cash, but it's actually capitalized or rolled up interest, which then accrues and is paid at the maturity date of the loan. The bulk of our loans are loans that have a contractual income and not a variable income component.

Jocelyn Lewis

Where there's not that private equity oversight, do you ever think that it's required to get more of a Board observer seat? Still being in the lender role like you just mentioned, but just the ability to have that additional kind of oversight that the Board of these companies would be discussing on a regular basis?

Christophe Rust

One of the key success factors in lending to non-sponsored borrowers is not only the credit selection and the structuring of the loan, but also around governance and controls in respect of governance.

The way we aim to achieve that is through a combination of means, one of which is in the form of quite comprehensive information undertakings, whereby the borrowers typically share with us monthly management reporting, which means that we are able to monitor the performance of the borrower in more or less real time.

Secondly, because we are negotiating and structuring these loans directly with the company as opposed to indirectly via a private equity sponsor, it means we have direct open access to management and oftentimes and indeed, typically, the shareholders.

And these are quite personal relationships. We also have quite extensive set of negative and indeed also positive undertakings to which a borrower is subject. So they can't just do what they want. They can do things within a certain remit.

And in terms of the Board seats or Board observer seats, the answer is that we do, on occasion, have either Board seats or Board observer seats. Whether or not we do is a judgment call that we make on a case-by-case basis. One thing we need to be careful of as a lender in Europe is that in certain jurisdictions such as in Germany, there are risks of being both a lender and a shareholder or a lender and director.

And the risk is called equitable subordination risk, which means that in the event of an insolvency of the borrower, if the lender is either a shareholder as well or a director of the company, that loan extended by the lender may be deemed by court not to be a loan anymore, but as equity. And that's not a good thing because you could be subordinated to many other claims.

Chris Sparenberg

We're hearing a lot about the rise of asset-backed lending. We'd love to hear you kind of explain asset-backed lending for those of our listeners who may not be familiar with this type of financing and to walk us through the key factors that make it an appealing option.

Christophe Rust

Our loans in contrast to being cash flow loans must be secured by some kind of asset. Now that asset can be either a real asset such as real estate or equipment inventory or infrastructure or it can be a financial asset such as a trade receivable, it could be a financial receivable. It could potentially be a portfolio of investment holdings or indeed long-term contractual income.

The point is that in having some kind of asset backing, it is more likely in the event of a default for the recovery of the loan in a default scenario to be much higher than what the recovery of a loan that is purely based on cash flows is. And what we want to offer our investors is exposure to a portfolio of loans that have target returns in the mid-teens, but without taking significant risk of capital loss.

Jocelyn Lewis

And Christophe, also a topic that comes up regularly in discussions with private credit lenders is the topic of tracking covenants. So can you tell us a little bit about the types of covenants you have in your deals and how they're structured and then monitored to safeguard both lenders and borrowers?

Christophe Rust

Absolutely, Jocelyn. We typically have 3 financial maintenance covenants that are tested quarterly. Now we may also have more than 3. Indeed, we've got one loan that has 5, but I would say that is the exception.

Ultimately, what we're solving for is a set of monitors or risk management metrics that allow us to have a discussion with the borrower in the event -- for whatever reason, whether that's to do with the borrower's own performance or the overall market conditions that we are able to discuss with the borrower the performance and what needs to be done to improve performance, if need be.

And so concretely, what kind of covenants do we have? We have typically the following, we'll have a debt service coverage ratio, a maximum leverage ratio. We typically will have a minimum liquidity covenant as well. And depending on the kind of deal, we may also have a maximum loan-to-value covenant.

Finally, we may have some more bespoke covenants that are specific to the sector or business. But in the main, these are the 3 to 4 covenants. We have certain rights in the event that the business plan isn't performing according to plan, and they're very effective in doing that.

Chris Sparenberg

So one thing that's undeniably clear is across the board, institutional investors allocations to private credit are increasing.

Christophe Rust

What we see at the moment is that a lot of asset owners have already allocated portions of their alternatives, portfolios to private credit. However, they have done so naturally enough by doing so in the form of investments in sponsor-focused direct lending managers. The journey that they are still on is with respect to adding to those core private credit exposures, some exposures and strategies that are more differentiated and can be complementary to those core exposures of theirs.

And that is where a strategy such as ours, which is more niche, which clearly is differentiated, can be relevant. Because what we offer to investors is a number of what we believe to be valuable aspects, namely one, that in investing in our funds, they have access to lower mid-markets in Europe to which they otherwise would probably not have so easy access.

Jocelyn Lewis

Where are you seeing opportunities in today's market? And what insight can you share in your outlook for the coming years, particularly considering evolving economic conditions and the market dynamics?

Christophe Rust

Our view is that there's a very broad-based opportunity set in the European mid-markets that we target. Largely for the reasons that I mentioned at the beginning, namely that the European capital markets simply don't cater to the funding needs of these lower mid-market borrowers and the banks continue to retrench.

And what that means is that there is a high demand for funding across sectors, across geographies in Europe that simply isn't being met. There are sectors where that funding demand and that funding gap are more pronounced than others. And those sectors include notably real estate, where there is a very large demand for real estate owners to both secure funding for developments, but also for refinancing.

And it's a very deep and broad and multifaceted opportunity set that we would flag as being a very fertile one. We also see extensive opportunities in the renewable energy space. So we've been quite active in the solar and wind spaces in Europe, where we see massive demand for capital, but also a limited supply when it comes to certain kinds of transactions and markets.

And we also see opportunity in the specialty finance segment of the market. So I would say real estate, renewable energy and specialty finance are 3 specific segments of the broader opportunity set that we're excited about.

Chris Sparenberg

Well, Christophe, thank you so much for joining us today. It's a fascinating discussion about your European opportunistic credit strategy and its unique differentiators compared to the mainstream credit strategies and some important structural considerations that are really unique to what you're doing.

Christophe Rust

Thank you so much, Chris and Jocelyn. It's been a real pleasure speaking with you.

Chris Sparenberg

Thank you again to our wonderful guest for a great chat today. Really appreciate everyone listening in. If you're looking for more private markets content, hit subscribe to catch future episodes and listen to our earlier episodes wherever you listen to podcast. Cheers everyone.

Jocelyn Lewis

Thank you so much. You can also subscribe to our monthly Private Markets 360 newsletter. The link is in each episode or connect with us on LinkedIn. Have a great day.