European Direct Lending Adapts to Shifting Capital Markets

In Brief: Howard Sharp, Chairman and Co-Head of Direct Lending at Alcentra (a Franklin Templeton subsidiary), shared insights on the European private credit landscape in a recent S&P Global Market Intelligence podcast. With over 35 years of credit market experience, Sharp highlighted how the market has evolved following the 2022 interest rate increases, which caused a 40% drop in mid-market activity. He sees positive signs for 2025, noting increasing market segmentation between lower, core, and upper mid-market lending, with each segment attracting different investor types. Sharp emphasized the importance of rigorous underwriting and restructuring capabilities while predicting continued growth in club deals, secondaries, and retail investor participation.

Big Picture Drivers:

• Market Segmentation: European direct lending is increasingly divided into lower, core, and upper mid-market segments

• Investor Evolution: Shift from defined benefit pension schemes to local government pensions and insurance companies

• Deal Activity: 40% drop after 2022 rate hikes with expectations for recovery in 2025

• Competitive Landscape: Broadly syndicated loan market has returned to compete with upper mid-market direct lending

Key Topics Covered:

• Investment Focus: Alcentra targets resilient B2B businesses with predictable cash flows in Northwest Europe

• Underwriting Process: Labor-intensive analysis with 90% of opportunities dismissed before first investment committee

• Capital Deployment: 60% of investments go to existing portfolio companies for growth

• European Complexity: Multiple jurisdictions, currencies, and legal systems create challenges but also opportunities

Key Insights:

• Restructuring Capability: Like fire extinguishers, restructuring expertise isn't needed often but is essential when trouble arises

• Geographic Strategy: UK offers strongest creditor protections in Europe, similar to US Chapter 11 framework

• Liquidity Premium: Core mid-market direct lending should maintain 150-200 basis point premium over syndicated loans

• Future Growth: Infrastructure and environmental impact funds present significant opportunity in Europe

By The Numbers:

• Deal Pricing: Core mid-market loans priced at 525-625 basis points over base rate

• Capital Sources: 70% of deals come through advisors, but only 18% of committed capital

• Private Credit Ratio: €70 billion of dry powder in private credit versus €370 billion in private equity

• Success Rate: 1 in 150 advisor-introduced transactions reach investment versus 1 in 13-14 from direct sponsor relationships

Memorable Quotes:

• "We don't have winners that can pay for losers like you might find sometimes in private equity." - Howard Sharp on the fundamental difference in risk approach between credit and equity investing

• "Trees don't grow to the sky... when does private credit stop being private credit if you create that level of liquidity?" - Howard Sharp questioning whether increasing liquidity in private markets might fundamentally change their nature

• "It's a little bit like you think of restructuring people like fire extinguishers - you need them all the time... when you smell smoke, you need that fire extinguisher straight away." - Howard Sharp on the critical importance of having in-house restructuring expertise

• "The US has the Holy Trinity of single language, single legal jurisdiction, single currency... whereas in Europe we have none of those things." - Howard Sharp explaining the additional complexity of European markets compared to the US

The Wrap: As European direct lending matures, Sharp believes the market will continue growing through increased segmentation, secondary market development, and retail investor participation. Success will depend on managers' ability to navigate complex jurisdictions while maintaining disciplined underwriting and restructuring capabilities. The key challenge ahead is balancing investors' demands for liquidity with the fundamental illiquidity premium that makes private credit attractive in the first place.