A coming of age story

Stephen McKenna, co-head, private debt and capital markets at SANNE, digests some of the biggest developments in 2018 for a maturing private debt industry and what they might mean for the fund services sector in 2019.

This article is sponsored by SANNE and first appeared in the Fund Services Report special supplement

The start of the year often brings with it a feeling of renewed vigor and a sense of excitement for the challenges ahead. However, with a stream of elections in emerging markets, and Greece, Poland and Ukraine going to the polls in Europe – together with an expected continuation of trade protectionism and, of course, Brexit – 2019 feels like it is going to be another eventful year.

Steve McKenna

Throughout 2018, we saw a number of large investors preferring to opt for a segregated mandate or managed account above entering into a fund directly. Alongside this trend was a noticeable increase in due diligence that the investors looked to complete before they committed their capital, including some very detailed due diligence questionnaires on the administrator. Although this is a valuable exercise it can also be a time consuming one. However, since most investors ask largely similar

questions, one can reduce the administrative burden by maintaining a central database of FAQs and keeping this information up to date. It is probably also worth pointing out that the due diligence questionnaires appear to be a lot more tailored to the asset class than they might have been a couple of years ago.

The more targeted due diligence queries we have received is indicative of investors continuing to increasingly recognise debt as an asset class in its own right and invest into more strategies. As this continues, one would expect to see a continued flow of requests for specific information or reporting provided in a certain format for comparison purposes. As the market continues to develop, grow and become more mature, perhaps an ILPA equivalent reporting standard will be introduced into the debt space.

“The more targeted due diligence queries we have received is indicative of investors continuing to increasingly recognise debt as an asset class in its own right”

Once investors are on-board, either into a fund or through their own account, it seems that they increasingly like to receive their reporting through an online portal. Sending emails with statements attached feels like it will gradually fade away as we continue to see more and more emphasis on information security. We fully expect this trend to continue into 2019 and the use of interactive portals will be the norm in Europe as it already is in the US market.

The green and the good

Continuing on the trends in reporting, a pleasing development has been the growing focus on Environmental, Social and Governance. The London Stock Exchange has issued guidance setting out recommendations for good practice in ESG. The global guide responds to demand from investors for a more consistent approach to ESG reporting, which is now a core part of the investment decision process. It was recently reported that Chicago Teachers considered managers’ workplace diversity as a factor in their investment selection. In addition to being up to speed on best practice ESG reporting, perhaps the increased due diligence on administrators will expand further to consider administrators’ positions on key ESG indicators as part of the selection process too.

The FCA also issued a discussion paper in December in relation to climate change and green finance. We will need to see what comes from this discussion and feedback but it could potentially result in further disclosure requirements and a standardised framework to improve investor understanding of an investment’s environmental impact. Due to political pressure and advancements in technology, it is not surprising to see a few predictions being bullish in relation to the growth of the renewable energy market over the next few years. It will be interesting to see how much of a contribution debt plays to this market.

Our accounting team have been busy evaluating the impact of International Financial Reporting Standard 9 – a new accounting standard for financial instruments – since it will come into play for the December 2018 annual accounts currently underway. Full retrospective application is required, as is a detailed note to the financial statements showing the effect of adoption of IFRS 9. However, the comparatives are not required to be restated. Instead, the effect of adoption of IFRS 9 can be presented simply as a movement in reserves. Nevertheless, it might be preferable to elect to restate if this results in a clearer presentation by enhancing the comparability of the prior year information, but restatement is permitted only if it is possible to do so without the use of hindsight.

Consolidation plays

Throughout 2018 it felt like there was a consistent move towards consolidating. We heard how there was continued capital consolidation; we saw joint ventures between managers and investment managers teaming up with banks. In the administration world, there has been continued consolidation with high levels of M&A activity and this is something we expect to see throughout 2019. As managers run increasingly complex, cross-jurisdictional products with higher substance requirements and more detailed reporting obligations, it is increasingly difficult for smaller firms to provide the services needed and to pay for the systems and infrastructure that is required to support these deals.

“In the administration world, there has been continued consolidation with high levels of M&A activity and this is something we expect to see throughout 2019”

One area that is always worth looking at when considering upcoming challenges is the regulatory horizon. Adoption, implementation and roll out of new regulation can significantly affect our industry and there is a heavy schedule of future disrupters. In 2018 we saw substance rules introduced alongside the Anti-Tax Avoidance Directive in Luxembourg and General Data Protection Regulation, to name a few. The 5th Anti-Money Laundering directive is expected to come into effect by the end of 2019 and primarily deals with the use of digital currencies and advances in the financial technology space.

We saw several enquiries in relation to fintech and blockchain throughout 2018 and this growth area certainly feels like it will have an increasingly important role to play in the future economy. Therefore, the need to ensure that the supporting regulatory framework is up to speed is being addressed by the next installment of the AML directive. Administrators will have a key role to fulfil, as governance and robust controls will be fundamental to maintaining confidence in the industry.

Substance has also been an ever-increasing area of scrutiny and focus with the introduction of the EU substance requirements together with best environmental practices. One can be sure that this will continue into 2019 and beyond. The days of postbox companies are virtually gone from all but a few of the less professional jurisdictions. Now administrators need to take care that they are fulfilling the requirements and guidelines to avoid bringing any dispute about the domiciliation of a structure they are looking after. This includes making sure meetings are properly convened and held regularly, management and control is demonstrated, and books and records are maintained and completed to a high standard.

As a final thought, although fundraising slowed last year compared to the bumper 2017, it is widely believed that the private debt market will continue to grow over the next five years. Some predictions even show the market doubling in size over that time. Aside from the growth itself, it will be interesting to see how much our industry evolves and what contribution private debt will make to the future global economy.