•  The European financing environment for SMEs and MidCaps has changed dramatically in recent years. One of the most striking changes is that more and more companies are now raising capital by borrowing directly from private investors. However, the future success of Europe’s growing “direct lending” segment depends not only on the regulatory environment and monetary policy framework, but also on how well these alternative investment funds perform. Their performance, in turn, is largely a function of investment strategy and accurate credit risk assessments.
  • This analysis first shows that SMEs and MidCaps in general are subject to higher credit risk than global corporates. Nevertheless, up to one third of European SMEs and MidCaps have a high creditworthiness. A comparison of the credit risks of SMEs and MidCaps in Germany, France, Italy and Spain further reveals that cumulative default rates and rating distribution can vary significantly between countries. Apart from the country-specific risk structure, our analysis also identified differences in corporate credit risk within sectors, some of them considerable.
  • An accurate assessment of the credit risk of European SMEs and MidCaps must be based on a wide range of factors. Assessments should consider not only the unique characteristics of SMEs and MidCaps, but also risks specific to the country and sector. Only a careful analysis of all relevant risk factors will produce an accurate assessment of corporate credit risk. Consideration of these different risks is absolutely essential for the direct lending segment, particularly as it establishes investment criteria, selects companies to invest in and manages overall risk.  


Direct Lending Funds Investing Ever More in SMEs and MidCaps in Europe

The complex change processes sweeping through financial markets as a result of structural adjustments and tighter regulatory requirements for banks have visibly affected the European environment for SME and MidCap financing. One example is nonbank financing for small and MidCap companies, which political and regulatory bodies have been pushing with increasing vigour. This trend has been fuelled by an upwelling of interest among institutional investors in alternative investment funds (AIFs). One class of AIF that has gained particular significance in recent years extends loans directly to European companies. These “direct lending funds” allow institutional investors to invest directly in a loan portfolio broadly diversified across asset classes. Direct lending funds come in two types: loan participation and loan origination. 

Significant Increase in Private Debt Fund Volume in Europe

Direct lending funds are growing rapidly in Europe, allowing the continent to catch up to the United States, where private debt funds have been playing an important role for some time.  

The cumulative volume of fully invested private debt funds has risen dramatically in Europe over the past decade. According to a survey conducted by Preqin, a data and intelligence service, strong growth in direct lending played a big role in lifting the European private debt fund market above EUR 100 billion for the first time in 2016. By mid2017, the cumulative volume had reached EUR 144.4 billion. That means that the European private debt fund market grew faster between 2013 and mid-2017 than the US market, which nonetheless remains significantly larger at around EUR 400 billion.

The rapid growth of direct lending in Europe translates into an ever-larger market share for this segment. Direct lending funds in Europe grew by 60% on average between 2007 and mid-2017 until they held nearly half (47.7%) of the market, followed by real estate and infrastructure funds with market shares of 37.3% and 15.0%, respectively. The investment strategies of direct lending funds lean heavily toward diversified investing. According to Preqin’s analysis, 79.8% of the funds in Europe spread their capital across industries. Direct lending funds focus in particular on medium-sized companies. A survey conducted by Allen & Overy showed that the majority of investors plan to increase their investments in such companies.

We assume that private debt funds will continue to gain importance in Europe in the years to come. Our assumption is based on two facts: First, unlike banks, private debt funds operate under the public radar and are still less strictly regulated than their banking fellows. Second, institutional investors have shown growing interest in alternative investments. However, the success of Europe’s direct lending segment depends not only on the development of the regulatory environment and monetary policy framework, but also on the performance of these alternative investment funds, which is largely a function of the investment strategy and the fund manager’s ability to accurately assess the risk associated with their loan portfolios.  

Risk Profile of SMEs & MidCaps Shows Strong Differences Across Countries

Assessing the credit risk of European SMEs and MidCaps is a complicated endeavour, often more challenging than evaluating multinational corporations due to the specific traits of smaller enterprises. Indeed, SMEs and MidCaps can only be assessed accurately with a methodology tailored specifically to the characteristics of these companies. Another challenge in assessing the credit risk of European SMEs and MidCaps is the need to consider unique features of the company’s country of domicile. Differences in accounting standards and tax laws do cause deviations among financial ratios used for ratings but may not necessarily affect default rates. Other national idiosyncrasies, in contrast, may have a significant impact on corporate default rates, as shown below.

Significant Differences in Default Rates of SMEs and MidCaps in Europe

Figure A shows the cumulative default rates for Germany, France, Italy and Spain as calculated from the data1 used for this analysis:

Figure A: Comparison of default rates2 of SMEs and MidCaps in Germany, France, Italy and Spain