The journey to reducing credit intermediation by banks in Europe has been slow. The continent remains a heavily segmented, bank relationship-oriented market. Still, innovations adopted in the U.S. are finding space in some European markets. The private credit market's growth has been spurred on by over a decade of easy money and a search for yield, and grow it has--assets under management (AUM) have quadrupled in the past 10 years.

In this report, we answer frequently asked questions about how, in times of higher (real) interest rates and subdued growth, the risks and opportunities of private credit could have increased implications for the market as a whole. While banks and lenders have both benefited from the increase in private credit to this point, a shock to private credit could reverberate throughout the financial system in unexpected ways.

How Has Private Credit Developed In Europe?

The European private credit market largely developed as bankers saw opportunities to provide cash flow-based loans to middle market companies outside the traditional regulated banking environment. At its core, this meant bilateral private lending to speculative-grade companies at floating rates. Recognizing the benefits of security and seniority in the capital structure, in many cases, this implied they could generate acceptable returns on capital through the cycle.

Banks benefit from reducing their capital allocation, retaining a relationship with the business, and ability to provide auxiliary services, while leveraging the lending expertise of private lenders and the committed capital they can provide. Borrowers also benefit, most notably in obtaining relatively fast financing directly with private credit funds and avoiding underwriting and other transaction fees. Overall, the cost of funding, while higher, is not uncompetitive. And terms and conditions are tailored to meet the requirements of both parties, although maintenance covenants are required for all but the largest deals.

The expansion of the market has not come without growing pains--a key one being originating suitable transactions. The European loan market remains fragmented with a strong home country bias. This entails having a strong presence in the country where the business is located, with a competitive advantage for those that have partnerships with domestic commercial banks or groups with an established private equity presence, leveraging referrals to their more recently established private debt arms. According to the National Bureau of Economic Research's report, "A Survey of Private Debt" (published in 2023), 40% of European respondents have affiliated private equity businesses.

How Do Europe And U.S. Private Credit Differ?

Types of lending:   Private credit can generally be split into the following categories:

• Direct lending
• Junior capital (subordinated debt)
• Special situations, including distressed debt, mergers and acquisitions, divestitures, and spin-offs

According to the Proskauer Private Credit Survey 2023, European private credit vehicles are less diverse than in the U.S., with a greater focus on direct lending and special situations, as opposed to hybrid debt-equity solutions, asset-based lending, and venture debt.

Funding sources:   Financing for lending activities predominantly come from private funds, managed accounts, and from institutional investors (and sophisticated investors) in both regions. In the U.S., retail investors can access private debt markets through business development companies, a structure that is not available in Europe.

Market size:   The European private debt market is about half the size of the U.S. in terms of AUM, at $460 billion versus $982 billion as of first-quarter 2023 according to Preqin. This includes "dry powder" (undisbursed capital) of about $142 billion.

Transaction size:   The sweet spot for direct lenders in Europe are loans of €100 million-€350 million, corresponding to companies generating €20 million-€60 million of EBITDA--smaller than the median in the U.S. However, the growth in private capital and increased competition has pushed private debt providers increasingly towards larger transactions, where private debt (often a club) is competing more directly with the broadly syndicated loan market.

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Geographic and sector activity:   PitchBook data highlight, unsurprisingly, that the largest European markets have the greatest deal origination. The U.K. leads so far in 2023, with 27% of Europe's direct lending deals, followed by France at 21% and Germany at 16%. Sectorwise, as direct lenders have become more selective to limit credit exposure to more cyclical and challenged sectors, the largest number of private debt deals have involved professional and business service companies, with health care and tech slightly behind, very similar to the U.S.

Innovation:   One innovation of note relates to reforming the European Long-Term Investment Fund (ELTIF) concept, designed originally in 2015 to raise nonbank financing for long-term infrastructure projects and small and midsize enterprises. ELTIF 2.0, which takes effect Jan. 10, 2024, makes it simpler and more attractive for professional and, importantly, retail investors to invest long-term in the real economy.

How Do We View The Risks To Private Credit in Europe?

In any assessment of credit quality, financial risk typically carries a higher weight for speculative-grade entities. In that context, tighter financing conditions (encompassing funding costs, availability, and associated terms and conditions) is the key risk our Credit Conditions team in Europe has identified. This is particularly pertinent for private debt-funded companies, where maintaining liquidity and cash-flow-related credit ratios are essential indicators of viability.

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Another high risk is that Europe will get dragged into recession. Economic growth is currently weaker in Europe than the U.S., reflecting higher energy prices; greater geopolitical risk in the region (including the Russia-Ukraine and Israel-Gaza conflicts); gradual fiscal stance tightening; and a regional economy more exposed to China's slowdown (especially Germany, which is already in a borderline recession), meaning that credit quality could erode more quickly than in the U.S.

The scale of private debt in Europe is unlikely to threaten financial stability by itself as the disbursed amounts translate to about 1% of European total nonfinancial corporate debt (data source of total nonfinancial corporate debt: Institute of International Finance). However, as one of several types of opaque, illiquid unregulated markets, systemic shocks could expose vulnerabilities (principally involving excessive leverage, liquidity, or counterparty risks) elsewhere in the financial system, as has happened before. Moreover, information asymmetry becomes more important when less sophisticated retail investors can access the asset class. The launch of ELTIF 2.0 vehicles in early 2024 will amplify this.

With a significant amount of European debt maturing soon (€415 billion of speculative-grade debt in 2024-2026), private credit becomes a potential facilitator to refinance or provide additional capital to support amend-and-extend corporate situations. Distressed debt opportunities will also appear, because many companies have yet to face the reality of unsustainable capital structures given high interest rates and slow growth, especially now that costs are becoming harder to pass through.

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