Private Credit: Opportunities and Challenges for Businesses in Italy
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September 25, 2024
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Business Transformation and Financial Restructuring experts Claudia Lotti and Giovanni Patricelli discuss the current dynamics and future prospects of private credit markets in Italy. They have contributed their thoughts in an article recently published by Il Sole 24 Ore and available here.
What would you say are the main features of private credit markets in Italy today?
Some of the main features of private credit markets in Italy today naturally reflect (a) the recent evolution in local economy and industrial context, (b) the dynamics of state-backed support during covid and post-covid phase out, (c) the trend in interest rates and (d) the recent evolution in regulation.
In terms of local economy and industrial context, Small and Medium Enterprises (‘SME’) share of the country’s Value add is notably more significant than in other countries. As an example, for 2023 Italian SMEs contributed to c. 63% of the country’s Value add compared to Germany (c. 47%), France (c. 42%) and an EU27 average of c. 52%. The vast majority of these SMEs remain today directly owned or controlled by the families that founded them. The combination of these two factors (high prevalence of SMEs and family ownership) determines a rather ‘traditional’ approach to funding, that still heavily leverages long-lasting local relationships and high street banking vs alternative forms of funding incl. private credit, especially if from international institutions.
In more recent years, and particularly in response to extra-ordinary events such as COVID, some of the forms of government-backed emergency funding (e.g. guarantees) and the prolific investment activity of state-owned financial institutions such as Cassa Depositi e Prestiti (‘CDP’), contributed to partly disrupt historic equilibriums and opened the way to both opportunities and challenges for private lenders. On one side, government intervention by way of guarantees to COVID-impacted companies allowed the traditional banking system to generally keep lending, by taking the ultimate default risk of counterparties away. On the other, the implicit highly volatile situation well favoured more flexible players such as private lenders to join the fray, especially in more opportunistic situations requiring dedicated due diligence and tailor-made structuring.
Connected to the above, interest rates started to rise dramatically from 2022. Within mid-market, this contributed to a reduction of the existing spread between traditional lending products and private credit which in turn reduced the opportunity cost for a borrower to look away from traditional banking and into alternative source of funding. Looking at large-caps, higher intertest rates impacted valuations within the M&A market slowing down leveraged finance activity, an historical feeder of public High Yield and widely syndicated markets. At an extreme, public debt capital markets experienced a de-facto halt in 2022, with companies in need for opportunistic capital or facing maturities to refinance left with mostly private credit institutions to look to.
Finally, within the last ten years, Italian regulation has improved the country’s attractiveness to international investors by, among other things, progressively loosening entry barriers in terms of accreditations to invest via approval/supervision by regulatory bodies and significantly reforming the restructuring law.
Let’s look at some numbers to quantify latest trends…
Data from the “Italian Association of Private Equity”, “Venture Capital and Private Debt” (“AIFI”) shows that, in recent years, total investments in private credit in Italy have increased significantly, from around EUR 1.3 billion in 2020 to around EUR 2.9 billion in 2023. Despite a slight slowdown in 2023 compared to 2022, this growth indicates a positive consolidation of the sector.
Within the above figures, the attractiveness of the Italian market for international investors has also grown thanks to a series of reforms that have simplified the barriers to the entry of new capital and significantly changed the bankruptcy law. International players have seen a considerable increase in the volumes invested in recent years, rising from around EUR 1 billion in 2020 to more than EUR 2 billion in 2023, accounting for 75% of the total amount invested in 2023 compared to 25% for domestic players. This growing interest is indicative of confidence in the stability and opportunities of the Italian market, which offers fertile ground for diversifying investors' portfolios.
Bringing the above together, although 2023 saw a slowdown in private credit activity compared to 2022, an exceptional year we must say, an overall positive trend appears consolidating in the country, with international players more and more interested to diversify their portfolios in the region.
What makes private credit products competitive or less so?
Among the pros, three Ps: Pace, Personalisation and Privacy.
In terms of pace: Private credit providers are lean decision makers with often faster credit processes than traditional banks. They tend to be more demanding in terms of diligence but are used to ask for information clearly and directly, making for a more linear, quicker investment process. This is critical for fast-paced acquisition processes, to name one.
When it comes to personalisation, Private Credit is less of a standardised product than traditional term loans, High Yield bonds or syndicated leveraged instruments. Clauses and covenants are left to bilateral negotiations and there’s general openness to tailor credit documentation to the situation at hand, rather than a strong(er) reliance on market precedents, momentum or syndicating potential. Furthermore, flexibility in credit docs better reflects the risk-return opportunity of riskier situations in terms of security, credit tiering or general permitted leverage, capturing segments of the lending market that Banks or credit markets won’t be interested in.
By definition private credit is, well, private. This comes in handy particularly in large tickets deals as an alternative to the amount of disclosure required when tapping public debt capital markets. This is not to say that private credit documentation will allow for looser forms of monitoring and control, quite the opposite is often the case in fact. But information flow within the boundaries of a private bilateral relationship requires far less investments of time and structure by borrowers than e.g. quarterly public disclosures to a wide investor base or formal rating processes.
The other side of the coin is mainly Liquidity (or rather lack thereof) and Price.
Liquidity-wise, Private credit products are not publicly traded. Although sometimes listed (e.g. ‘Minibonds’, bond issuances reserved to SMEs with amounts less than €50m typical of the Italian market), there’s no active trading on these instruments and bid-ask spreads are left to bilateral negotiations within ad-hoc circumstances. Illiquidity comes with a risk compared to publicly traded or widely syndicated instruments such as High Yield bonds or leveraged loans to mention two examples.
All pros mentioned above, together with an illiquidity premium, lead to a higher price tag. As commented earlier, this becomes less of a in issue in times of either lack of valid alternatives, as in 2022, or when interest rates are generally high in the market but otherwise may restrict the attractiveness of the instrument to a narrower set of circumstances (e.g. opportunistic M&A, bolt on acquisitions, asset based lending, unsecured structures, Holdco PIKs, mezzanines etc.) or market players (e.g. sponsor owned vs sponsor-less).
All above considered, what does 2024 and beyond look like?
It would be difficult to draw a straight line and we will have to keep an eye to different factors coming into play.
No one can say for certain how fast and how much interest rates will go down but it is reasonable to assume that a market expectation of interest rates to keep going down in the near future favours lending activity in general, particularly for borrowers that have been waiting for sensible market windows to refinance. This is even more important considering that state-backed support has now been phased out and many corporates will need to seek funding at market terms again. Furthermore, M&A activity should be picking up on the back of (once-again) marketable valuations for entry-exit and sponsor-backed counterparties in particular are expected to actively seeking funding.
Which triggers the question: who are borrowers going to turn to?
SMEs looking at their relationship banks may be surprised to find less enthusiastic counterparties there. Banks are now facing significantly higher costs of capital to lend and SMEs may be less structured (i.e. potentially riskier) counterparties to hold on balance sheet. Furthermore, gone may be the times when state-guarantees allowed Banks to significantly reduce RWAs. This could be an opportunity for private credit providers, assuming proper due diligence allows an efficient selection between virtuous and less-so counterparties in a post-covid scenario.
On the other hand, large corporates may find that a scenario of lower interest rates makes the public bond markets and wider syndicated loan markets functioning and attractive again. An Itraxx Xover index at around 300bps (vs ~650 in 2020 and 2022) as we are witnessing these days is a signal of public market activity. This may take away some of the opportunistic private credit plays we have witnessed in 2022, with unitranche financing possibly losing ground.
Published
September 25, 2024
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