Europe overcomes its leverage stigma

A willingness for funds to offer leveraged options is enticing more investors from the other side of the Atlantic.

It’s often said that you should never rush to conclusions. Was the global private debt fundraising decline a sensible pause for breath on the part of investors that had committed unprecedented sums to the asset class the previous year? Or was it more of a case of taking fright over concerns about economic and political volatility – as well as increasingly questionable deal structures?

It may take a while before answers to these questions become apparent, but one thing that can be seen clearly from our recent fundraising presentation is that Europe bucked the trend. Almost 30 percent of private debt capital raised in 2018 was for funds with a sole focus on Europe – the first increase in funding for the region (relative to the rest of the world) since 2014.

Sources have told us that one factor relevant to the increasing popularity of the region is the increasing willingness of European managers to offer leveraged options at the fund level. Leveraged private debt funds have long been a part of the landscape in the US, where investors have become entirely comfortable with the role of leverage in enhancing returns. In Europe, until recently, this has not been the case.

Part of the cultural shift towards embracing fund leverage may be put down to the growing presence of US-based managers in the region. Ares Management, for example, has been going gangbusters on the fundraising front – including closing its fourth European direct lending fund last year on €6.5 billion, which rose to €10 billion including leverage. Not bad for a fund with an initial hard-cap of €4.5 billion.

Of course, not everyone has the same pulling power as the big brand names. One market source pointed out to us: “There are still plenty of direct lending funds offering unleveraged only. Ares and others are able to offer levered and unlevered options and ask investors which one they want. In the end, it boils down to your view on the manager. How good will they be at choosing the right credits and making sure the right protections are in place?”

There can also be concerns over how the leverage might be used – just for deals, or might it also stray into other areas such as manager compensation or hedging? Another focus is how the leverage is put together (normally by way of a bank facility with appropriate security). If it’s not structured correctly, it could potentially fall foul of regulations, such as the Alternative Investment Fund Managers Directive.

But what does appear to be changing is the perception that relatively low-risk strategies such as direct lending should necessarily be unleveraged because of leverage’s association with high risk. The boundaries of risk appetite are now being tested in Europe in the same way that they already have been in the US – and it’s a development US LPs appear happy to support.

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