The direct lending landscape has evolved. Baring’s Stuart Mathieson explains how investors can access the opportunity without compromising discipline.
The direct lending market has undergone tremendous growth over the last decade, with Europe accounting for a significant share. While still smaller than its North American counterpart, the European direct lending market today is estimated to be between $500bn and $1tn.
For investors, it’s important to understand how the direct lending landscape has evolved in conjunction with its rapid growth. Today, the question is less whether to participate and more how to access the opportunity set without compromising discipline. Along these lines, there are three key trends worth monitoring today:
1. Competition is high, but there is a flight to top-tier managers
In Europe, the last five years have seen an influx of new managers into the direct lending market, with competition increasing as a result. Yet, deal flow has continued to consolidate around fewer, larger and more stable managers that have both scale and incumbency. In 2024, for instance, the top five managers accounted for roughly half of all transactions completed in Europe. So, while competition is high, access points to well-constructed, diversified portfolios – particularly in the core middle market – have narrowed.
The heightened competition in the market, coupled with slower deal flow and muted M&A activity, has affected deal terms and pricing structures, although the extent of the impact depends on where a manager is transacting.
While these dynamics have driven pricing tighter overall, margin compression is more pronounced in the upper middle market. In the traditional middle market, terms look more favourable. Despite tighter spreads, origination yields have remained robust, at roughly 9% for the last 12 months through June. The market also continues to offer a premium over the broadly syndicated market, to the tune of 200-250 bps – suggesting private equity sponsors remain willing to pay a premium in exchange for resilience, reliability and certainty of execution.
It is also worth noting that muted deal flow has been a greater issue for platforms heavily reliant on M&A for origination and growth. It has been less of a concern for established lenders with large existing portfolios and the ability to source differentiated opportunities and deploy capital via off-market origination or add-on transactions.
That is to say, when it comes to accessing the opportunity in the traditional middle market, incumbency and scale matter, and will likely continue to drive significant origination and opportunity as sponsors grow their investments. A stable and permanent capital base can also provide an advantage, enabling managers to continue deploying capital at attractively priced opportunities, even as deal volume fluctuates.
2. European LPs are diversifying beyond the UK/Europe
Five to 10 years ago, private credit was largely considered a satellite strategy. Today, many LPs have increased their private credit allocations and broadened them to include a variety of sub-strategies and/or span multiple regions.
Within Europe, for example, the UK was the first to adopt direct lending on a significant scale, and even up to five years ago, 70-80% of the volume in the European market was happening in the UK. France, Germany, and the Benelux countries were next, followed more recently by southern European countries like Spain and Italy.
Investors are also increasingly considering global strategies that look across North America, Europe, and Asia Pacific with the aim of capturing relative value across geographies. There are several advantages to a global approach. For one, it increases the opportunity set of potential investments and, by extension, allows private credit managers to invest more selectively.
Because competitive dynamics ebb and flow (and differ) by geographic region, a global approach also allows managers to efficiently ramp a well-diversified portfolio without the pressure to invest in assets from a given region at a point in time when relative value is less attractive.
But these strategies – whether pan-European or global – are complex. Each of these markets and jurisdictions has its own legal systems and tax regimes, underscoring the need for large and highly specialised teams with local expertise and linguistic skills, and a thorough understanding of the dynamics that drive each market.
3. Sponsors are doing more with fewer managers
Sponsors increasingly prefer to transact with fewer managers as they look for strategic ways to add value and reduce their cost bases over time. For many, this means partnering with global lenders who can transact at scale and provide financing solutions in multiple currencies and across different jurisdictions.
Additionally, many sponsors are considering both current financing needs and future financing needs, sometimes looking out two to three years. Bank disintermediation is arguably still in the early stages, and as bank balance sheets continue to shrink, managers that can provide an expanded range of financing solutions will likely be at an advantage.
In addition to senior direct lending, this could include areas like capital solutions, portfolio finance, asset-backed finance, and equity co-investments – all the way to public credit market financing support.
Ultimately, lenders with the capabilities and breadth to support these requirements are in a good position to serve as strategic partners to sponsors and source attractive, through-the-cycle investment opportunities for investors.
For Professional Investors / Institutional only. This document should not be distributed to or relied on by Retail / Individual Investors. Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 25/4893249
