Balancing the market

This article is sponsored by European Investment Fund

How has the demand for private debt evolved in Europe over recent years?

Although banks are very supportive of small business financing in Europe, capital constraints following the global financial crisis have restricted the credit they can offer. Institutional investors, on the other hand, are long-term investors and are not constrained in the same way.

In the private debt space, institutional investors, by way of private debt commitments, have made more flexible and tailor-made financing solutions available to small businesses in need of support for transformative events, growth and innovation projects, so have been best placed to commit resources to finance the economy in a long-term and sustainable manner. As the availability of private credit has grown in Europe, so has demand from small businesses for this flexible and bespoke financing.

How does the EIF look to participate in the private debt market?

Small businesses make a vital contribution to Europe’s economy, and the EIF believes it is essential to improve access to finance for these businesses.

One of the ways in which we support the growing private debt market in Europe is to take cornerstone investments in new funds, supporting their fundraising process, and encouraging institutional investors to enter the space.

This is something we have done for a number of years, in fact so far we have run due diligence on more than 35 private debt funds in Europe, which in turn are targeting a combined €10.9 billion in commitments.

The EFSI Private Credit Tailored for SMEs Programme was launched in December 2018 to further encourage a real alternative to traditional bank loans for SMEs.

As part of our mandate under the European Fund for Strategic Investments (EFSI), we are targeting a much wider investible space – the traditional private credit market, of course, but also funds raised by first-time teams in new geographies, and also funds investing through crowdfunding platforms, which can target broader diversification across smaller businesses.

We also hope to attract a much broader investor base – for example, more institutional investors such as smaller pension funds and insurance funds – to ensure a widespread and long-term investment flow into this important and growing market.

What are the advantages of committing funds as an anchor investor?

By taking a cornerstone investment in a new fund, we help the fund to reach its target size, allowing it to actively start offering alternative financing to SMEs. For a first-time team or a fund in a new geography, the EIF’s participation can be a crucial source of advice on market best practices and governance.

Outside of the practical support, a cornerstone investment by the AAA-rated EIF is a ‘stamp of approval’, telling institutional investors that this is an important, alternative asset class. As institutional investors ‘crowd in’, the signaling effect magnifies, as does the capital flowing into the space.

“Small businesses make a vital contribution to Europe’s economy, and it is essential to improve access to finance for these businesses”

Under the EFSI Private Credit Tailored for SMEs Programme, we may also offer prospective investors unfunded risk protection to encourage their participation, particularly if they have not invested in this asset class before. This will always be done on a case-by-case basis.

What is your investment approach?

The EIF is contributing to the development of a structurally balanced private credit market in Europe, so diversification is important. We support fund managers that focus primarily on senior loans and we also like to support funds that are engaging in niche strategies, such as asset-based financing.

We work with new managers and we work with existing managers with established strategies, but we don’t work with the really big funds. The upper part of the private debt market is well-supported and our job is to focus on the SME space where there is less information, less of a historic track record and more diversity in terms of the types of business and how they operate.

We want to be comfortable that the fund managers in which we invest are operating with a sustainable business model and are in line with our objectives. The value we add is that we provide them with our own knowledge, our own screening process and our input into the governance of the fund, to ensure it is a viable and attractive investment product.

How do you mitigate the risks associated with offering private credit in this way?

This asset class is at the intersection of credit markets and private funds. The EIF has more than 20 years’ experience in both credit portfolio risk and private fund investments, giving us almost unparalleled understanding, market reach and screening ability.

“We want to expand the market so that, in a few years’ time, institutional investors have a much wider universe of fund managers and strategies through which they can diversify their own exposure”

When analysing a fund, we focus on the available skill-set and the capacity of the fund manager to implement the strategy that has been presented to investors. This includes fundraising, origination, underwriting, monitoring and workout capabilities.

A considerable amount of time is dedicated to the governance of these funds and the fund managers. In addition, we spend significant time on credit risk quantification, testing the managers’ assumptions regarding the target portfolio and return, utilising market data and EIF internal data. To date, 1.5 million SMEs across Europe have benefitted from EU resources through the EIF, giving us a good understanding of how SME credit risk behaves. We need to be fairly comfortable with whether the return targeted is achievable and is commensurate to the risk that is being taken.

How much has your geographic focus changed? Do you have much focus outside of the core European private debt markets?

When investing public resources, EIF balances a market approach with a developmental purpose. Our mandate takes a pan-European approach to the asset class, supporting a single European private debt market that is inclusive of all countries and financing situations where the penetration of alternative lending is still limited.

We want to expand the market so that, in a few years’ time, institutional investors have a much wider universe of fund managers and strategies in Europe through which they can diversify their own exposure.

Will the UK’s exit from the European Union impact your focus?

The EFSI Private Credit Tai­lored for SMEs Programme is sponsored by the European Commission so clearly the main focus is on reaching SMEs and small mid-cap business within EU member states. While a UK departure influences the investable universe, the EIF experiences substantial market interest from right across the EU. However, to some extent selected funds may finance businesses in the non-EU space.