Opportunity set for European Private Credit: US vs. European Direct Lending

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley. I'll be your host. Today's topic is the European credit market and how it compares to the US, particularly in the middle market segment. We're joined by two experts today, Chris Parisi and Andrew McCullagh of Hayfin Capital Management. Gentlemen, welcome.

This podcast is intended solely for institutional investors. The opinions expressed in this podcast are for general informational purposes only and are not intended be an offer or solicitation to buy or sell securities from any Hayfin entity and should not be relied upon to evaluate any potential investment. Hypothetical or projected returns are discussed and do not represent results actually achieved by any portfolio of Hayfin. There are inherent risks and limitations associated with relying on hypothetical performance to make investment decisions. Hypothetical performance results are speculative in nature and should not be relied on by investors. Additional information is available upon request. Neither Hayfin nor any of its affiliates makes any representation or warranty, express or implied, as to the accuracy or completeness of the statements or any information contained in this podcast and any liability therefore, including in respect of direct, indirect or consequential loss or damage, is expressly disclaimed. Past performance is not indicative of future results and a risk of loss exists.

Andrew: Thanks, Stewart.

Chris: Appreciate the time today.

Stewart: We're very happy to have you on. Andrew, your title is Managing Director and Private Credit portfolio manager. Chris, your role is partner solutions team and leading the insurance effort here in the US. Andrew, you're based in London. You're based in New York, Chris, just to give everyone the lay of the land. Is that all fair and good?

Chris: Perfect.

Andrew: Very fair and very good.

Stewart: All right, thank you. So we'll start this one the way we start them all. How about home town, first job, fun fact? Chris, we'll start with you.

Chris: Home town's Eastchester, New York. First job was a caddy at a local country club in Bronxville, New York. Fun fact is I'm just back from visiting Disney World with my wife and two young daughters.

Stewart: Oh, there you go. How about you, Andrew?

Andrew: Home town, London. I'm afraid I'm born, brought up, educated, and worked no more than about 20 miles from this particular spot. So sadly a very parochial Londoner. My first job was I worked for a local building site. I drove a tipper truck when I was about 17 years old, which was pretty terrifying for me and probably more terrifying for those people around me. Sadly, the most interesting thing about me, I have six kids, which sort of defines me, quite frankly. I don't know if it's fun, but it is quite fun.

Stewart: That is fun. That's fun stuff. So today we're going to talk about the European credit market and in particular, let's start off with what's happening in the global market. What does it mean for a private credit manager, especially one that is European and in a rising rate environment?

Andrew: So, markets have become much more interesting. As I look through my career, I guess we go through periods where there's a degree of stability, markets are performing in some sense, and then bow to volatility. Life only gets more interesting when things get more volatile.

And obviously, markets today are dealing with a huge amount of uncertainty and uncertainty in a different environment. The fact is uncertainty for a long time has meant a positive thing. Bad news has meant the Fed opens the liquidity spigot again and markets actually benefit, but we’ve sort of been in this topsy-turvy world for quite a long time.

Now with the inflationary backdrop, the higher rate environment, and that reverse we've got a bit more volatility, perhaps, than we're used to. The market is dealing with the uncertainty of a potential recessionary environment. We've got the ongoing supply side issues post-COVID, labor constraints, higher energy costs, particularly in Europe, and the potential for recession. So there's a lot of uncertainty out there and that's what we're seeing in markets.

Stewart: And you mentioned Europe, and Europe is getting a lot of negative attention. That includes the gilts market, the war, energy, and inflation. Where do you see value in that market?

Andrew: Well, there certainly is a lot of attention on... Europe is sort of a rather leapfrogged US. I think if we were talking 18 months ago then I think people were probably more concerned about the embedded nature inflation in the US, a rate tightening cycle, the US perhaps leading the world in terms of what that might mean in terms of GDP and potential recession.

Europe has rather leapfrogged that with everything that's happened this year in Ukraine and it's an uncertain environment. Look, I'm a credit guy and so I kind of always assume the downside. I think here at Hayfin we try not to predict too much. There are some very big-brained economists who will have a view, although some will get it wrong, but they'll have a view about what might happen next year. But because we're credit people obviously we always assume their worst, and I think it's going to be potentially difficult in Europe next year.

Does that translate into a moderate recession, a severe recession or are we going to have some respite? Not quite sure. And obviously, what we're doing here at Hayfin, we're fundamentally a credit shop and I think perhaps today focusing particularly on our direct lending product as a senior secured product, we're lending money to mid-sized corporates. Then the whole essence of the product is that it's supposed to do well in a downturn.

Indeed, if you had a very bullish view on what was going to happen in the world, then perhaps you'd want to take a bit more risk than would be embedded in a senior secured mid-market product. So of course, given the backdrop of what we're seeing in Europe, we're being very selective, obviously very much looking for those types of businesses that are not exposed to consumer discretionary expenditure, not exposed to inflationary pressures, and making sure we protect our downside.

And overall given the disruption where, or potential disruption we're talking about, typically that's where you find better value. It's hard to find good value when everything's performing and risk appetites are high and there's go, go, go in the markets. Quite frankly, without wanting to sound too optimistic about next year or too naive, rose-tinted about it, I feel rather more positive about finding good deals to do and good value in the next 12 months than I felt perhaps for the last 5 or 6 years.

Stewart: That's interesting. And I mean you mentioned the senior secured nature of the lending that you do. Can you talk about what sorts of areas that Hayfin is going after and what are some of the key metrics that you're looking for?

Andrew: So in the end of the day, what we think we are doing at Hayfin in particular in this direct lending strategy is delivering a risk profile to our clients. We are lending money, we're not buying companies, we're not running companies, we're just finding risk that we like and that hits a particular risk profile. What is that risk profile? It is one where we think the risk of default is very low and the risk on loss of default is really, really low. I would like to say zero. I mean there's always risk out there, but this is very much meant to be the type of product that people don't worry about when the world's upside down. We can talk a bit about what happens in default scenarios, what that means in the European context, but this is very much a product where people can feel confident that they're going to get their capital back and the return as advertised.

Now what does that mean in practical terms? That means that we want to see as many deals as possible out there. We want to have as big an origination net as possible. Because ultimately when it comes to credit selection and insofar, as we all know, the curse of being the debt provider is that you only ever get your money back. There's no upside. There's no deals that kind of make the fund, which means it's all about saying ‘no’ most of the time and just selecting those deals out there that you feel really, really comfortable about, even in a nasty recession environment are always going to give your money back. So what deals do we focus on? The answer is we try not to have a particular focus. We want to see everything, we have as broad a net as possible.

A lot of our deals, as would be the case in the US as well, are driven by the private equity world. And private equity owners are great borrowers. They do good corporate governance, they do good diligence, but they're also incredibly sophisticated users of capital. In other words, when you talk about value, how much value do you get on that loan to the private equity guy? Well the answer is he's going to make sure that's as limited as possible and they have great ways of extracting value from direct lenders. But of course, we have a lot of those in our origination book or what we look at. But we try and spread our net wide. So we look across not only that traditional sponsor opportunity but on other types of owners, a more diversified series of private owners across Europe. We like to do that by looking at different industry verticals.

We've got a healthcare vertical, we very much like healthcare deals. We look at that in a broader sense. We look at certain asset-orientated verticals where we see particular residual value, for example real estate. So I would say there's nothing that particularly defines us as such as that. What we're really trying to do is build a team that can access as wide an opportunity set as possible so we can be really credit-selective. Credit selective when times are good because it's competitive, credit selection when the world's looking like it might get upside down because we can move into those areas we think are really particularly well downside protected.

Stewart: So can you give me an example of what a typical deal might look like that Hayfin would like to see or is doing?

Andrew: Sure. So it's a broad spread of different types of borrowers, but if there was a typical borrower, as you said up front, this is mid-market lending, what do we mean by that? That's a borrower with an EBITDA of somewhere between €25 and €100 million or $25 to $100 million, median size about €40 million or so.

We tend to be levering that business between four and a half to five times. So we're typically providing a couple hundred million euros of debt that typically is done where we are the sole lender. So on a bilateral basis. It is done with a good old-fashioned traditional senior debt document with all the typical documentary provisions. They've come under some pressure in the last 10 years, but they're still fullydocumented with maintenance covenants, and the median spread that we get from those borrowers between 600 and 650 base points, that's over a floating rate cost of funds with about a 3% front end fee.
So we're looking basically at generating gross yields across a portfolio of somewhere like 9% to 10% or net yields to our class in a kind of 7% to 8% context. I know it's been going up recently because obviously, it's a floating rate product. So we benefit from that but in a broad context - that's the typical deal for us.

Stewart: That's really helpful. And so we're talking about private credit here and one of the things that I think might be helpful to our listeners is if you could give a comparison of the US versus the European private credit market, just in terms of market depth and deal size and leverage and enhancement and whatever. I think it would help for those who might not be as familiar with the European direct lending market.

Andrew: Sure. I think the first thing to say is that there are more similarities than there are differences. So I mean the fact is this is corporate lending. These deals will look, smell and behave in a very, very similar way. Not surprising, as I said, the private equity wealth is a key driver. A lot of those private equity firms are global in nature. So these things are very similar.

There are a few nuances in Europe. Europe is a little behind the US. We tend to find things that happen in the US tend to get imported over here in Europe with a kind of 3 to 5-year delay. In a credit cycle quite frankly that's a positive and it's like all the bad things happen towards the end of a credit cycle, there's more risk being taken and lending terms tend to get worse. So here we've had, perhaps, an easier time in terms of documentation than perhaps in the US. Very recently we've had some of the Cov-lite trends that we've seen in the US be imported here into Europe.

But I think there are more similarities than are differences. I'm a creature of the European market. I've worked in the European leveraged market mid-market for my entire career. And so of course I've got a natural prejudice towards Europe. Of course, Europe is better than the US. I think there are arguments as to why some of those mid-market companies in Europe have perhaps a higher residual value. I mean if you think about your typical €40 million EBITDA business, in a European context given it's relative jurisdictional complexity, that could well be a market-leading business in this jurisdiction as opposed to the US where it's probably a small minnow in a kind of broader market context. And of course, when we're doing our lending, it's just all about finding residual value, finding those businesses that can't go away. They're an embedded part of the system and I think that's probably easier to find in the mid-market than in the US.

But I think perhaps conceptually, I think the more interesting and perhaps bigger difference between the US and Europe is really in the structure and how business is done. And I think, again, I'll make broad generalizations, of course life is a bit more complicated than this, but the US is a big deep established market, very well-established players. It is a reasonably straightforward place to do business. You have a single language, a single rule of law and you can credibly run a business, an origination team out of New York and do the US. It's accessible, it's rational.

Europe is more complicated. Europe is obviously broken down country by country. It's a much more idiosyncratic place to do business. It's not clear that you can, in fact I know you can't, originate business sitting in one city. I sit here in London, there's that kind of the arrogance of Londoners that kind of everything important happens in London. Demonstrably not true.

We have a team in Paris and Frankfurt and Milan and Madrid and my French team are very clear, if a French deal goes to London it's because everyone in Paris has said no, because we do all the best deals. And that's right. The way it works. What that means is that Europe is a more difficult place to originate in. It's a more expensive place for a direct lender to do business because he has to invest in a bigger, broader, deeper, more diverse team across Europe. And that really rather defines how Europe operates. And also I think when you're looking at managers and different managers and how they approach that, because obviously if you're a GP, if you're debt managers as we are and we all like to be profitable, which moreover means we want to be efficient, the most efficient way to do business in Europe is you sit in London, you build a team in London, which is a big market, London sees a lot of deals, and you focus on private equity deals because they're the easiest deals to originate. That means you can manage quite a lot of money with a small efficient team, if you like to be profitable like our US counterparts. The problem, of course, is that's what everyone does. Everyone sits in London and everyone focuses on private equity deals. So in fact you end up with quite a competitive niche in that European context.

But of course in a rather more interesting way and where the opportunity in Europe is more interesting is if you embrace that complexity of Europe. So if you are prepared to invest in a team that can source locally and look at deals away perhaps from that traditional private equity space, then actually you find more interesting deals. Capital doesn't move as efficiently across Europe as it does in the US. I mean the US, big market, how much value can you really get? Well it's different, it's very accessible. Europe is less accessible, precisely because people don't want to spend money on that complexity. So if you can embrace it, at least the theory goes, Europe becomes quite interesting.

Stewart: And it's interesting, you talked a little bit about this, but I want to kind of touch on results. So the delivery of income, the diversification, you mentioned originating locally. Can you talk a little bit about how you stress test and what your workout process is if things don't quite go the way that it was intended.

Andrew: So as I said, I think what are we doing in direct lending? We're delivering a risk profile. That risk profile has got to be zero tolerance. This is kind of where we'll always get the capital back. You do that through building your origination machine as I described, and investing in that and making sure, again, this is just around deal selection. This is just about having a big enough pipeline to be able to say ‘no’ most of the time. So you can just select those deals that you're really, really comfortable about and having an origination machine, that means that hopefully you can steer away from those parts of the market that are getting too competitive, of limited value, and focus on where there's less capital around. And of course, the essence hopefully is that you make no mistakes, but mistakes happen also. It is a risk product.

Things go wrong. We can go into recessions and however smart you are, business gets impacted risk by recession. So to deliver on that risk profile, you have to make sure you can manage your portfolio effectively and always get the capital back. And again, having sort of made the speech around Europe being a complex place to originate deals, Europe is a very complex place to manage a portfolio.

You work out an enforcement, which is extreme- that's not plan A, but sometimes it has to happen. That means quite different things in different jurisdictions. Indeed, I gave the comment that you want to be local in Paris to originate good deals. You really want to be local in Paris to enforce on a business. I can tell you from past experience, France is a court-driven process in enforcement and the courts in France really don't care if it's a Brit like me sitting in London waving a flag, asking for their money back. You want to be in Paris. Preferably you want to have gone to school with the court appointee, the mandataire, that's the kind of way it works in France. So it's a question of again, building that team, that broad team across Europe that can always recover capital in any circumstance and drive the ultimate result, which will be consistent risk and consistent return profiles through the cycle.

Stewart: And Chris, I want to bring you in here. I know that you lead the efforts in the insurance space and obviously, diversification of a middle market lending program is one of the reasons that people would go to Hayfin. Can you talk a little bit about insurers’ access to the asset class, the capital efficiency, and operational efficiency?

Chris: Yeah, certainly. And thanks, Stewart. And I think as we think about that, different jurisdictions are going to mean different things. In Europe some of our insurers are going to want to own this risk in a separate account format and work closely with us to get the analytics to be able to take this to a rating agency and get a rating on it. Given that we're working with a private asset class that is unrated, particularly in the US we're thinking about ways that we can deliver this solution, realizing the underlying is mostly denominated in euro, but there could be elements of sterling.

We have a pretty robust hedging program here at Hayfin where we're able to deliver back dollar exposure, but European credit risk, but package that up into a rated notes here. Securitizations are not new to insurers and something that they've invested in many years. Obviously, CLOs have been quite prominent within insurance company portfolios north of $200 billion exposure in the US. So leveraging that technology to deliver our strategy is something that we're very focused on and have been engaging with lawyers and with rating agencies in order to do that.

We're thinking about it from the lens of efficiency and we run very diversified portfolios. So thinking about many of our vintages having north of 70 or 80 loans over a three-year investment period, but package that into a structure that we really think makes a lot of sense for a US insurance company.

Stewart: And maybe I should have started with this, but for those who aren't as familiar with Hayfin, can you give a little bit of background about Hayfin, how long you've been in business, what you're managing, and just kind of give us a little bit of background. I think it would be helpful.

Chris: Yeah, certainly. So we were founded in 2009, initially backed by private equity money. Today we're partially owned by British Columbia Investment Corporation, the $200 billion Victoria-based Canadian pension plan, who's been our partner for now for the better half of five years. But folks would have known us from our founding in 2009.

Today, we manage over $25 billion of assets with a liquid credit business that is global and a core to our business is private credit. So you think about where Andrew has spent a little bit of time today, but focused on senior secured direct lending as our flagship. But really a private credit platform that extends all the way up to special situations. Over the life of what we've done, we've made over 400 loans to European middle-market companies and our focus is Western Europe. So as you know, Europe is obviously a big place, but really with a focus on UK, France, Germany. As a platform, the furthest that we've lent is Austria. That's kind of the line of demarcation for listeners today.

Stewart: That's really helpful. And I always tell people on all these podcasts, I'm the one who learns the most. And so I've had an opportunity to get a really good education on the European credit market and the European direct lending market in particular. I've spent a fair amount of time as a professor and I have a soft spot in my heart for people who are just starting out their careers. So I'll direct this last question to Andrew. So as you look out at the landscape in Europe in particular, as you think about coming out of university as a young person starting your career, what advice would you give your 21-year-old self?

Andrew: That's a very good question. I've been born lucky. When I was a student at university, what was my career aspiration? Well, I was a chemist studying philosophy and I thought art restoration was kind of the right thing and I just fell into this leverage finance role that was kind of some backwater back in 1989. And that then kind of turned into this enormous beast that I've ridden the wave, quite frankly. And as ever, it's not great advice, but it kind of is. 'Better lucky than smart' might be my general feeling of life. I can tell you one of the things, what advice would I give my 21-year-old, especially a 21-year-old who then suddenly has six kids is something?

Stewart: Yeah, there you go.

Andrew: Learn how to play golf before you get married because the fact is you'll never learn it after that.

Stewart: That's great advice. That's great advice. Thanks very much for being on. It was my pleasure to have you. We've been joined by Chris Parisi and Andrew McCullagh of Hayfin Capital Management. Gentlemen, thanks for taking the time.

Andrew: Pleasure, Stewart. Thank you very much indeed.

Chris: Thanks so much for having us today.

Stewart: Thank you and thanks for listening. If you have ideas for podcasts, please send me a note at podcast@insuranceaum.com. My name's Stewart Foley and this is the InsuranceAUM.com podcast.

The InsuranceAUM.com podcast is available on