As the coronavirus struck Europe in March last year, many thought direct lenders would be on the chopping block. The vast majority of such funds had not yet been through a downturn, as alternative credit only truly blossomed in Europe after the last financial crisis, and its focus on funding mid-cap corporates was seen as a possible weakness. Making matters trickier, the asset class is yet to develop a robust secondary market, so funds could not even cut their losses by trading out of their positions.
But so far, direct lenders have managed to weather the pandemic relatively unscathed. There have been pockets of problems with investments in retail and hospitality, for example, but few defaults and nothing approaching a systemic problem.
Portfolio managers argue this is down to rigorous credit work and the ability of portfolio managers to work with borrowers and sponsors quickly and flexibly. As direct lenders provide debt bilaterally or in small clubs, there are fewer competing interests to deal with. Also, they give credit to European governments, which rolled out generous fiscal packages to help companies through the pandemic.
Direct lenders are by no means not out of the woods yet, according to Flynn. Inflationary pressures may force central banks to tighten monetary policy and governments will likely reign in fiscal measures. But the funds which focused on senior secured lending in defensive sectors, Flynn argues, did well through the crisis so far.
The big question for the asset class in Europe is how much market share direct lenders can take from the incumbent bank lenders. Banks pulled back from lending to the middle market through the coronavirus crisis, and Flynn expects them to cede more ground to direct lenders in the coming years.
GlobalCapital: Has alternative credit been vindicated through the coronavirus pandemic?
Tim Flynn: So there are two pieces to the answer. If you are looking from the perspective of May 2021, you have to observe that direct lending has fared quite well. But that’s not the full story.
On the positive side, and to personalise the answer, as an organization we’re built for exactly that kind of environment. We recognize our asset class can be very cyclical — earnings are cyclical, markets are risk on then risk off. There are challenging times and that’s the nature of the beast.
To prepare for this, we have to be thoughtful with our portfolio construction. Alternative asset managers which focused on senior secured loans rather than subordinated bonds, as well as lower rather than higher leverage, with tight rather than loose documentation, did quite well.
But it’s too easy to sit here and say it was a successful Covid. The fact of the matter is it was extraordinarily painful for everyone. Hayfin has a senior secured, low leverage, risk-averse approach to portfolio construction, and even we had something like 25 investments in our direct lending portfolio that required major care and attention — defaults, liquidity needs and even one debt-for-equity swap.
We had companies with zero revenue. Prior to Covid, it never occurred to me that that could be possible. None of our downsides had anywhere near close to zero revenue.
There are also pretty significant opportunity costs. When a team focuses on its existing portfolio, it is harder to focus on deployment. We said at the beginning of March 2020 on our investor calls that we thought it would be a very, very profitable deployment opportunity. The reason we’re built for this is we have a very significantly sized and experienced workout team. We had a lot of stress in the portfolio, which was time intensive, but ultimately we had no losses.
On the flip side, we had extraordinarily active deployment, putting more capital to work last year — some €3.7bn in direct lending —than we've ever deployed.
Is it too early to say the asset class has shown its resilience?
We’re not out of the woods yet. I’d say we are at half time. I don’t know the score — perhaps 1-1, maybe we’re now in the lead. Covid scored early on, but then we got our act together and perhaps got a goal or two back.
But we had a very friendly referee for the first half with an unprecedented, globally coordinated policy response — unlike the last crisis — which was signalled early. This is why we thought there would be a great deployment opportunity with the drawdowns in valuations. That fiscal stimulus bailed everyone out. Without that response, I suspect we’d all be in a quite different place.
What happens as that policy stimulus begins to unwind? How’s our portfolio going to fare through the inflationary pressures? It feels like we’re either looking at inflation or rate rises as upcoming risks. It’s premature to take the champagne out. We’re in a very odd set of circumstances, like nothing I’ve faced before in my career — and I doubt anyone else has.
Without the friendly referee, there would be more winners and losers; and we would have been much more active in our distressed business.
But has the performance of the asset class through Covid so far pushed more investors into the product?
One would have to say it is a fairly accommodating environment for fundraising. That's driven by a number of factors. Firstly, direct lenders came through Covid so far, and most are in good shape. There’s another factor in that direct lenders’ portfolio valuations are less volatile than public markets, so some of the stress is less visible.
The European alternative lending market has seen extraordinary growth over the past decade, which is fundamentally driven by regulation and banks’ capital requirements. My assumption is that that regulation was purposefully designed to push more lending out of the banks and into the hands of people like Hayfin.
That continues at pace. One stat from the recent University of Oxford Saïd Business School report on European direct lending was that the ratio of bank assets to GDP dropped from 350% in 2008 to approximately 250% in 2018. Our sense is that continues to go in the same direction, so the underlying market growth is very strong. Though there’s a lot of capital coming into direct lending, what that capital is doing is soaking up the demand from the mid-cap universe due to the banks’ retreat.
The other thing, of course, is low rates. If a pension fund is trying to make an acceptable return on its assets, private credit continues to look very attractive. Generally speaking, senior secured lending continues to carry lower risk of loss than other corporate asset classes.
You hear a lot in direct lending about the banks retreating from middle market lending — do you think that has sped up through the pandemic?
What we observed in 2020 is the European banks stepping away from new deployment. There were hung syndications and discounts to par, with many smaller direct lenders doing the same. At the beginning of the second quarter through to the fourth quarter, there were very few lenders on the front foot.
That was largely due to resources, and perhaps a bit of fear on risk committees. When you go through something like Covid, there's so much work that needs to go into the portfolio. The time intensity of defending its value is extreme. Only the lenders with very big teams and big workout capabilities were able to deploy.
We saw the biggest direct lenders in Europe on the front foot. We saw everybody else largely on the sidelines, including the banks. That is based on my intuition and what we saw in the trenches.
In some senses, 2020 was a missed opportunity for special situations. Does this prompt some soul searching within the business? If you have immense fiscal packages being thrown across the market during crises, the opportunities are fewer for special situations groups.
It's nuanced. Our experience during Covid was we actually deployed quite a lot of capital — around €1.2bn — last year in special situations. This is a much bigger number than our historical run rate, but it's a lower number than we anticipated.
If we break down the deployment of that capital, part was the easy secondary trade — par loans that traded at 80 cents for a short period of time in the second quarter.
But we were anticipating much more of our bread and butter: rescue financing, providing liquidity, balance sheet restructurings and the like. That happened to an extent, but the necessity for it was significantly impacted by the fiscal policies. Why would you restructure your balance sheet if you don’t have to? Why ask Hayfin for a super senior liquidity line at a 15% to 20% cost of capital when your national government is offering debt at 2%?
How does Hayfin protect itself in situations like this? We’re in a privileged position to have raised a lot of capital, but we raised less capital that we thought we could. We decided to not maximize funding, and made sure we had a very long investment period to deploy it.
But it is reasonable to assume the policy response will unwind, and we'll begin to see more dispersion and more winners and losers. When that happens, we would expect an increased flow of the classic business of balance sheet restructuring, liquidity lines, liquidation, claims and that sort of activity.
What's your view on consolidation within alternative credit? Some people think Covid will prompt consolidation between different managers.
Actual consolidation, where two managers become one in the same space, is something I hear a lot about, but I’ve seen very little evidence of it. I think the business case is relatively weak for consolidation plays with other managers in the same space — certainly for the acquirer.
However, there are a couple of things happening that will likely continue. The big will get bigger and medium-sized firms will continue to specialize, employing new strategies that the bigger players either don't want to do or don't have the capabilities to do. The subscale players, at least from what I've observed, are not looking to sell themselves to the big guys. They are looking for partners, just like Hayfin did 12 years ago. We have a fantastic partner in British Columbia Investment Management Corporation. BCI has been our long-term partner that’s helped us grow, and helps us with capital. We share information with each other and leverage each other’s origination and underwriting.
Other managers are having lots of conversations about similar types of partnerships, maybe not with a Canadian pension fund, but with other platforms that are relevant but not in the same business — relevant for distribution, capital, underwriting and origination.
You don’t think the market in Europe will become saturated?
It's a very complicated question. In one sense, of course there’s saturation — that’s what happens with zero rates. That’s why equity, real estate and high yield valuations are where they are. That’s why there's so much money in the direct lending space. It's a phenomenon of capital markets.
But it's more nuanced than that. The European alternative lending market continues to grow because banks’ balance sheets are being transferred to direct lenders. At some point in the future, the asset class will stop growing, but I don't see any evidence of that yet.
We can't do anything to control rates. We can't control capital markets. We're in a cyclical asset class, which is competitive. We’re not building rocket ships, this is a commodity business — it’s just money. What we can do is make sure we deliver thoughtfully constructed, appropriately structured, properly priced portfolios to our clients.
The most important thing we can do is operate a very big book, and have a large team on the ground locally — which we have, with over 130 people all over Europe and teams in the US and Singapore. In moments where there's heightened competition, where companies find their way through investment banks and brokers to auction off assets, we've set ourselves up so we don't have to participate in these deals.
We also have a very broad mandate. We recognize that sometimes certain parts of the market are over-heated. A third of our book is not from the sponsored market, and the dynamic is much less competitive in the non-sponsored world. Why is it less competitive? Because it's less commoditised. There's fewer options and less sophisticated kinds of situations.
We also do a lot of secondary trading, unlike most direct lenders, and deployed a significant amount of capital last year in secondary funding — buying hung syndications that were set up to be syndicated in the CLO market, at a very meaningful discount.
We know there’ll be certain times we're not going to want to deploy. This quarter for example is relatively quiet — we’ve been selling more than we’ve bought.
The final thing is fund size. We would love to have €20bn to €30bn funds, but we know we can't deploy it. Now I'm not saying bigger fund sizes are necessarily a bad thing, but one has to be thoughtful about one's setup and strategies. You have to make sure you are not forced to deploy.
That’s the way we control it. Big teams with very broad mandates, tapping into sponsored and non-sponsored deals, and fund sizes that are modest compared to others. That's not just a Covid lesson, we learned that lesson 20 to 25 years ago.
You mentioned the non-sponsored part of the market. How much growth is there to be had in that area?
It’s less commoditised, often with better structures and better prices. But it’s much more expensive to originate. It comes back to what your goals are as a direct lender. If your goal is quarterly profitability, you wouldn’t play in non-sponsored lending — it’s too expensive. You’re much better off with the smallest team you can get away with doing as many PE deals as you can.
Our business model is we care about where we’ll be in 10 years’ time, and if we want to establish and maintain a leading alternative credit platform we have to deliver exceptional performance. If we’re going to do that, we have to set ourselves up with broad mandates and spend a lot of time in the non-sponsored world, when the sponsored part is over-crowded and competitive.
In truth, we would always rather be in the sponsored market. The deals are easy — they call you, you don’t have to call them. They tend to be well diligenced. But in order to construct the sort of portfolio we want to deliver, we learned a long time ago you can’t rely exclusively on them.
If you look at our non-sponsored business, most of the deal flow comes from three of our favoured sectors. The first is healthcare, where we finance pharma assets, devices, manufacturing plants and the like. We have made significant investment in a transatlantic healthcare team that have deep relationships in the pharma world, have been underwriting in this area for 20 years and understand the business models.
The second is shipping. I’m not aware of other direct lenders in that space, but it’s not for the tourist. We’ve invested over $2.5bn in shipping, without a loss. People get scared of the sector because a lot of people lose a lot of money in the space — but usually they don’t have the same experience, relationships and asset-servicing capability.
The third area in which we’re active in non-sponsored, asset-backed lending, is through our European real estate team, where we similarly have the relationships and specialised underwriting to originate less competitive, better structured, better priced situations.
You’ve previously said that Hayfin was here to try and look around corners. Are there new strategies you are developing, or are you simply growing in existing strategies?
We try very hard to be careful and diligent students of markets. This is a very odd moment. There are worrying signs in our portfolios around not just inflation but supply chains. One of our borrowers is a distributor and is worried about significant gaps in their ability to secure supply at any costs.
We’re beneficiaries of that in other areas. We own a platform in our special opportunities strategy which owns container ships. As that market has tightened we’ve been a beneficiary of inflation. To give you a data point on one of our vessels, which is relatively small, it went out to charter a year ago at $9k a day and we’re now looking at refixing it at $27k a day.
At the moment, we have to think about which companies we want to deploy in. If we are in an environment of persistent inflation, it’s very important our portfolio companies have pricing power. We need companies that have the ability to put their own prices up.
We’re also trying to think about which pockets are more interesting on a risk-return basis. Our tactical credit strategy — that sits between special opportunities and direct lending — can hold long-dated assets, and one of the things we’re observing is there’s an opportunity to buy long-dated sale-and-leaseback structures. These are largely sold by banks and insurance companies as the regulatory capital they have to set aside for those assets is proving onerous. These are 10-year deals, which are not loans or bonds but equity in an SPV, so the structure doesn’t fit into many direct lending mandates. But they are uncomfortable on banks’ balance sheets and very uncomfortable for insurance companies. We’re seeing them selling at discounts to intrinsic value.
Finally, how important is ESG to your business?
Responsibility has always been part of our culture and we embed it in our investment process and corporate strategy. It’s also very important to many of our investors. We’ve formalised our approach — we now have an ESG committee and an ESG investment subcommittee. We’ve recently been in the market to hire a dedicated ESG professional to help us improve more in this area.
We’re working on new initiatives, too, like membership of the UK Stewardship Code 2020 and the Task Force on Climate-related Financial Disclosures, in addition to being a longstanding signatory to the UN Principles for Responsible Investment. Diversity and inclusion is another key area of focus: we’re part of the steering group for SEO London’s Alternative Investment Programme to help under-represented groups access career opportunities in the alternative investment industry. We’re very focused on gender, ethnicity and social mobility.
We are a credit platform, and typically don’t control our portfolio companies. But we can incorporate ESG into our investment process, and focus on our own behaviour and our own corporate culture.
