Banks have long dominated corporate lending across Europe. Since the financial crisis, however, one cornerstone of the continent’s economy has increasingly struggled to access that capital

“The SME market in Europe represents a massive percentage of the non-financial economy,” said Patrick Dennis, co-manager of global credit and co-deputy managing partner at Davidson Kempner, highlighting that the majority of non-financial employers across the continent are SMEs.

However, as shifting regulation and operational constraints have made it more challenging for banks to finance SMEs, Dennis sees an opportunity to plug the gap through asset-based lending, which he views as a “huge addressable market” across Europe.

The USD 37bn investment manager provides ABL to businesses across Europe, typically in sizes ranging from EUR 25m–EUR 250m to both sponsor- and non-sponsor backed companies. Rather than borrowers turning to multiple lenders for capital, DK positions itself as a lender that can take a holistic view on a borrower’s balance sheet.

Real estate assets are a big focus of the firm’s European strategy, in part because they are often the main assets on SMEs’ balance sheets. The manager also provides advance rates against receivables financing, inventory financing, and machinery financing.

Part of the firm’s lending across Europe is conducted through BZ, which DK acquired in 2020. The specialist lender has originated over USD 1bn in loans and more than USD 7bn in revolving lending to mid-cap corporates since 2019. DK also closed a USD 1.1bn asset-backed private credit fund earlier this month, according to a press release.

Bespoke SME financing is far from a crowded market. Non-bank lenders have yet to penetrate the European market to the same extent as across the Atlantic. Europe has a notably lower leveraged credit investor capital compared to the US, with just 5% in GDP terms compared to the 12% in the US, and non-bank lenders in Europe have around 50% less private credit capital than in the US, a DK report shows.

Corporates across the continent source around 85% of their funding from banks, compared to 50%-55% in the US, according to UBS.

Since the financial crisis, however, SMEs have found access to bank funding increasingly constrained. Regulatory changes have upped the risk-weights banks face when lending to SMEs.  The implementation of the output floor under Basel III brought risk weighted assets for banks using internal ratings-based models (IRB) – typically larger institutions – in line with those of standardised approach banks, effectively increasing risk-weights asset classes such as SME lending. Banks also frequently lend against collateral across multiple jurisdictions, further increasing complexity and cost.

Against this backdrop, Dennis sees DK’s ability to offer bank-like services as a key driver of growth in the European SME market

“If a borrower calls and asks what its borrowing base is today, you need to be able to provide an answer,” said Dennis. “On our side, that’s required a significant amount of investment in both partnerships and systems to offer financing and an advance rate across a variety of different asset classes.”

For example, the firm calculates daily net asset values to help gauge the availability of working capital to borrowers. Compared to semi-annual corporate reports, daily NAVs also offer a handy surveillance tool by providing a regular window into company performance.

“It helps us to understand what we underwrote to, the borrowers’ business plan, whether there are any mile markers in the process and whether [the borrower] is on course to hit those,” Dennis said.

Asset-based lenders often bake other features into financing structures to keep a handle on risk. Asset-based lending structures usually enjoy cash dominion, meaning that cash borrowers receive from paid invoices are placed in a lender-controlled account. In practice, this means that the lender has initial control over cash inflows and can use them to repay the facility before releasing surplus to the borrower in the event of default.

Lending to companies looking to make acquisitions or invest is usually DK’s preference. “We are more comfortable with what the synergies or uplift could be with an acquisition or investment,” said Dennis, “From that perspective it builds more of an alignment of interest with the non-sponsor or sponsor.”