How have competitive dynamics in the European direct lending space evolved in recent years?
David Hirschmann: The direct lending market has grown significantly over the past two decades on both sides of the Atlantic, but the drivers have been quite different. In the US, growth has largely been propelled by a high number of new entrants. In Europe, by contrast, a relatively stable group of managers has continued to finance the majority of mid-market transactions, preserving a relationship-driven market.
More recently, some managers have scaled very quickly. In certain cases, that has led to capital being deployed more aggressively, with some loosening of underwriting discipline.
We have taken a different approach. Permira Credit has been active for nearly 20 years, with a consistent focus on measured growth. In direct lending, we prioritise originating a strong pipe-line of high-quality opportunities over raising excess capital. That discipline, in our view, is critical to delivering performance, and will become even more important in the coming cycle.
How are firms differentiating themselves against this backdrop in the direct lending space?
Benoit Vauchy: Deep, bottom-up credit expertise and restructuring capabilities remain incredibly important. Direct lending is now such a large part of the overall credit landscape that it is impossible to entirely avoid defaults. Problems are inevitably going to arise, and managers need to be able to respond to those challenges by providing access to operational and strategic resources – such as in-house restructuring and value creation teams – that are valuable in these more complex situations.
But our strong view is that the most critical differentiator in the market today is sector expertise. Most lenders held a fairly simplistic view on sectors until just a few years ago; in order to avoid the big defaults, they stayed away from certain sectors perceived as too risky or cyclical, such as chemicals, automotive and retail, while leaning heavily into software as a perceived safe haven. The advent of artificial intelligence, however, fundamentally questioned that logic.
Sweeping statements can no longer be made about lending into entire sec-tors. It’s crucial to be able to identify which individual software credits are good and bad, and understand why, for example.
Some players in the European mid-market initially responded to negative headlines by stating their intention to avoid AI risk. That is easier said than done; in fact, our opinion is that you cannot escape AI risk, regardless of which sector you are lending into. You must embrace it, and that is where having deep, embedded sector expertise really makes the difference.
Generalist private credit providers have to rely on the due diligence done by their clients. In our case, that will always be a sponsor, but in the general credit world it could also mean a corporate or an entrepreneur. The idea of outsourcing your sector perspectives to a third party, in particular today, feels dangerous. No matter how good that third party is, we believe a lender should always be able to form their own opinion on whether a business is an AI winner or an AI loser.
To form that view, that lender would either need to be extremely scaled to have real breadth across sectors or be genuinely embedded within a private equity platform with that depth of sector knowledge – the latter is true for us.
DH: Our edge comes from the depth of insight within our PE platform. Over more than 40 years, Permira has built sector expertise that feeds directly into our credit underwriting and investment decisions. Through close collaboration with dedicated, sector-focused teams, we are equipped to navigate complex situations and actively support portfolio companies through periods of change.
In a market where outcomes are increasingly driven by sector-specific dynamics, particularly with the impact of AI, we believe this level of integration and depth of understanding is not just a differentiator, but increasingly a requirement to deliver consistent performance.
Diversification matters in private credit where the focus is on risk management and capital preservation. How does that marry up with a trend towards greater sector specialisation?
DH: Diversification is of course extremely important, but diversification and sector expertise are not in conflict; in fact, they are both essential.
As Benoit mentioned, the emphasis of sector expertise used to be on avoiding certain sectors perceived as too risky, but the environment is evolving. Increasingly, the challenge is to differentiate between strong and weak businesses within the same sector. That is difficult to do without genuine depth of expertise.
Meanwhile, our focus remains firmly on downside protection and capital preservation. In private credit, returns are contractual and there is no equity upside, so avoiding losses is the absolute priority. We are not chasing innovation, we are backing resilient businesses.
For us, effective diversification is about limiting the impact of individual credit outcomes. Even where a default occurs, it should not materially affect overall fund performance. That requires disciplined portfolio construction and the ability to diversify underlying credit risk, not simply exposure across sectors.
BV: I would add that it is important to remember that diversification doesn’t provide complete protection. I have heard so many lenders say that their investors have no need to worry about AI because software only represents a certain percentage of their portfolio. We strongly disagree, because AI is ubiquitous. It is impacting just about every sector out there. You can provide some protection by making sure you have 50 or 60 names in your fund, but the most important thing is to avoid the big structural losers.
I actually believe that credit underwriting in these circumstances is easier than in equity underwriting, because in credit you don’t take nearly as much terminal value risk. You still need to avoid those big structural losers, however, regardless of whether their failures are caused by tech disruption, competitive pressure, regulation or changing consumer trends.
Sometimes we see examples of lenders simply upping the price if they are uncertain of the impact of those factors, but that isn’t the solution to this specific problem. The fact is that there are companies that you just shouldn’t be lending to at all. There is a fundamental threshold question that needs to be considered and if the answer is that a business is structurally challenged, it is imperative that the lender walks away from the deal.
Given that the next cycle is set to test managers’ capabilities more than ever, how should LPs approach underwriting managers in this period of constant volatility?
BV: Private credit performance was fairly homogeneous for a long period of time. Default rates were low and so, by definition, the performance of credit providers with similar strategies has fallen within a fairly narrow range. It has been a low-alpha, high-beta environment.
LPs are now starting to worry about increased defaults and are therefore thinking more carefully about how various credit platforms are differentiated. From our point of view, there are a number of ways in which investors can approach this question. The first is to make sure that a GP has not raised too much capital for the opportunity set it seeks to target. It is important that the managers don’t feel obliged to do every deal that comes across their desk. This is particularly relevant at a time when some managers are raising large sums of money from private wealth channels. Second, investors should consider whether the manager has deep sector expertise in order to avoid backing structurally challenged businesses. Third, they should consider whether the manager has a real track record of dealing with difficult situations because there is no doubt that more of those situations will arise going forward.
DH: My advice for an LP would be to back managers that have prioritised performance over asset-gathering. The so-called golden age of private credit rewarded deployment. The next cycle will reward discipline.
Do you think that a creeping misalignment of interest could cause problems for the private credit industry?
BV: LPs want managers to have a critical mass in order to be successful but they don’t want their managers to have so much capital that they are under pressure to deploy at all costs. That is inevitably when mistakes get made. Over the past two to three years, some of the big platforms have raised very large amounts of capital from the wealth and retail channels – in some cases, hundreds of millions of dollars every month.
There are only three possible out-comes of this trend: either the manager will start to lend more money against any given credit, they will lower their prices and loosen terms to take market share from competitors, or they will start taking risks that their competitors won’t. In other words, it leads to a compression on margins, a compression on terms, higher leverage and higher defaults. That is basic supply and demand dynamics.
The good news from an investor standpoint, however, is that this situation is starting to reverse and some managers that were experiencing hundreds of millions of incremental capital growth each month now see that capital flowing in the other direction. That should lead to better pricing, better terms and more discipline.
For our part, alignment with our investors has always been a priority. Permira has chosen to remain a private partnership and we only invest in two asset classes – private equity and credit – and the firm’s partners have committed significant capital to both.
That means our incentives are tied to long-term performance in a way that other firms with different business models simply are not. The mindset this creates within the firm shapes every decision we make on deployment and pricing, and should lead to strong outcomes, particularly in the next cycle
