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Risk-return decoupled: direct lending leverage ratios rise, but competition keeps margins stable

In a challenging macroeconomic environment, where rising interest rates stress debt on balance sheets, the leverage ratios of direct lending deals in Europe have continued to rise over the past 10 quarters, as Debtwire’s direct lending database shows.

The average ratio in Europe climbed to 4.6x in 2Q23 from 3.5x in 1Q21, a trend seen across all major regions. France recorded the smallest increase, as the leverage ratio inched up to 4.4x from 4.2x, whereas the UK’s average has rocketed to 5.4x from 2.9x.

Looking at the leading sectors in the market, leverage has been more volatile, but each shows a consistent upward trend, with all the main sectors demonstrating higher levels than in 2021. Leverage for deals in the services sector has escalated to 4.6x from 3x, while for firms in the TMT industry it jumped to 5x from 3x. Healthcare deal leverage hit 5.1x in 2Q23.

Margin resilience

By contrast, average direct lending margins have remained relatively stable since 2021. This stability is surprising given the leverage increase and higher-risk macro environment.

The average margin on direct lending deals has moved to 791 basis points (bps) from around 800 bps in 1Q21, peaking at 807bps in 1Q23 following a trough of 718bps in 2Q22.

Data also shows that stability is evenly spread among the main sectors, with healthcare, services and TMT deals pricing on average between 600bps and 800bps since the start of 2021. The exception is financial services, which has seen outlier deals boost the average figure in three of the previous six quarters, but with little impact on the general trend.

The data for specific regions has been more volatile. In the UK, one of the leading jurisdictions in direct lending, margins have only recently peaked in 2Q23 at 930bps. However, widening has been compensated by developments in other regions such as France and the DACH countries, where spreads have contracted since last year.

These numbers contrast with the large-cap loans space, which is also heavily linked to the Euribor inter-bank lending rate, but where margins have increased to 457bps from 398bps over the same period.

All this is happening in an environment in which direct lenders have been pushing into and challenging players in the syndicated loan space, showing an appetite to close deals with high leverage ratios.

On the other hand, while challenging syndicated loan players, direct lenders also face increasing competition in their own field.

Direct lending fundraising has seen exceptionally large executions over the past quarter, with Bridgepoint’s EUR 3.4bn fund closing last month and Permira’s EUR 4.2bn fund closing in mid-June. These add to the huge funds raised last year including a EUR 7bn offering from Barings, EUR 6.3bn from CVC and EUR 5bn from Ardian, among a plethora of others.

With more money to be invested in direct lending, borrowers are better positioned to fight for cheaper money, and therefore lower margins. This helps to explain the margin stability even when lenders face deal opportunities at levels of higher leverage.