The Rise of Asset-Backed Lending in Europe’s Private Debt Market

Feb 22, 2024 | News

The European economy, challenged by pandemic, inflation, interest rate rises, and geopolitical tensions, has created an uncertain environment, reminiscent of the post-Global Financial Crisis era. In this context, private debt and in particular asset-backed lending (ABL) and real estate debt have emerged as prominent alternative financing methods, filling the gap left by traditional banks constrained by regulatory capital limitations.

Investor sentiment is increasingly favouring providing loans to borrowers without involving traditional financial intermediaries like banks, as evidenced by the projected increase in assets under management (AUM) for private debt lending strategies. Preqin’s ‘Future of Alternatives 2028’ report anticipates significant growth in direct lending AUM, reflecting strong investor trust and confidence. This growth is driven by the attractive features of ABL including real estate debt, such as consistent returns and the security of loans backed by real assets. In a low-interest-rate environment, these type of lending funds offer higher yields compared to traditional fixed-income products.

Global private debt AUM is forecast to grow at a compound annual growth rate (CAGR) of 11.1% from 2022 to 2028, reaching an all-time high of $2.8 trillion[i]. This growth is expected to be particularly strong in North America and Europe, despite the latter’s challenging economic conditions. Within this, direct lending is projected to be the strategy with the strongest AUM growth – growing at 13.3% to reach $1.4 trillion in 2028[ii], driven by continued demand from investors and industry for flexible credit.

Across Europe, private debt AUM is forecast to grow at 10.0% annually between 2021 and 2027, reaching €646.6 billion in 2027, up from €365.1 billion in 2021[iii]. Whilst a more challenging economic environment will provide investment opportunities to support distressed debt funds, direct lending is expected to dominate private debt AUM, growing from €212.6 billion in 2021 to €422.4 billion in 2027, when it will account for 65% of private debt assets in the region[iv]. This is consistent with investors continuing to allocate capital into investment strategies supported by strong supply and demand fundamentals.

In response to inflation, central banks have raised interest rates, and in the EU, ABL and real estate debt funds are uniquely positioned to benefit from this scenario due to the floating-rate nature of most loans. This adaptability makes them attractive for investors seeking to hedge against inflation. Despite default rates rising in the mid-market, these remain relatively low, supported by resilient employment and continued wage inflation.

Amid a tightening monetary environment, the rate of fundraising for private debt has slowed as expected, yet it remains favourably positioned in the tighter credit markets given its exposure to higher rates through variable lending facilities – and we expect investors to increase allocations over the next 12 months as well as longer-term allocations. This reflects not only investor interest, but also recognition of the asset class’s potential to perform under various market conditions.

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Within non-banking lending itself, capital deployment is evolving with a shift towards more niche strategies, such as real estate debt. Investors are drawn to the security of real estate assets and the potential for higher returns, indicating a diversification of interest within the broader lending category. When compared to other private debt strategies like distressed debt, special situations, mezzanine, and venture lending, ABL often present a more conservative risk profile. While strategies like distressed debt may offer higher returns, they come with increased operational complexity, involving investments in companies facing financial or operational difficulties requiring specialised skills in areas such as corporate turnaround, bankruptcy law, and high-risk investments. Venture lending, targeting early-stage companies, often in the technology sector, offers high growth potential but carries higher risk due to the unproven nature of these businesses and the lack of solid collateral. This is reflected in investor sentiment with the two most favoured private debt strategies being direct lending (60%) and distressed debt (51%), when asked which funds present the best opportunities in the next 12 months.[i] Furthermore, direct lending’s low correlation with traditional equity and fixed-income markets makes it a valuable tool for portfolio diversification.

As we look forward, the prospects for ABL and real estate debt are promising, with expectations of continued AUM growth and strategy sophistication. With a deepening understanding of alternative lending among investors, innovation could lead to the creation of more customised fund offerings, designed to align closely with individual investor requirements. This evolution is likely to include a greater focus on sector-specific lending, enhanced risk management strategies, and innovative financing structures.

Private debt lending serves as more than just a financial tool; it also acts as a key driver for economic and social change. In Europe, where elevated debt levels constrain government investments, private capital, plays a vital role in bridging the investment gap. This is especially critical in supporting the transformation of Europe’s mid-market, the linchpins of the European economy. With only a minimal portion of their external financing currently sourced from private markets, there is a substantial opportunity for ABL and real estate debt to make a significant impact in sectors like digital transformation, supply chain fortification, decarbonisation, brownfield regeneration and urban repurposing, logistics, and healthcare.

Despite its growing popularity, private debt lending is not without its challenges. The increasing competition in the market could lead to compressed yields and higher risk-taking. Moreover, the evolving regulatory landscape could impact the operations of non-bank lending funds. However, these challenges also present opportunities for innovation and the development of more sophisticated investment strategies. The use of advanced analytics, artificial intelligence, and machine learning can enhance asset selection, due diligence, risk assessment, and portfolio management. This technological integration could lead to more efficient operations, better risk-adjusted returns, and a more personalised approach to lending.

In conclusion, direct lending, and in particular ABL and real estate debt have become leading strategies in private debt, offering stability, attractive returns, and portfolio diversification. As the landscape continues to evolve, these types of funds are poised to adapt, playing a crucial role in the broader economic fabric and potentially driving significant transformations across various sectors. The future of lending without involving traditional intermediaries like banks looks promising, with its potential extending far beyond financial returns, impacting economies and societies alike.

[i] Preqin, The Future of Alternatives 2028
[ii] Ibid.
[iii] Preqin, Alternatives in Europe 2023
[iv] Ibid

Source: Arrow Global Group

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