Harnessing the momentum of a buoyant market

By Adrien Rossion

The sixth edition of the KPMG/ALFI private debt fund survey published on 25 November 2022 reflected a steady growth for the private debt market that year. By confirming its ability to generate stable and consistent returns over the last couple of years, private debt assets have continued to attract investors.

Market conditions have been challenging over the past months with geopolitical uncertainties, rising interest rates and inflation and the reduction of bank lending activities. Under these circumstances, the Luxembourg private debt funds showed an impressive 45.4 percent average growth, with Assets under Management, reaching €267.8 billion by June 2022.

As of March 2023, growth expectations remain high for Luxembourg private debt funds: private lending should be fairly crisis-resistant and immune to inflation as it largely relies on floating rate characteristics and shorter maturities than traditional fixed income instruments. An exception to this would be fair valued loans paired with longer maturities. Due to increased interest rates, which are used as discount factors in valuation, the fair value of such loans could significantly decrease.

If the decrease is considered longer than “short-term” those assets would need to be impaired. In the worst-case scenario, a potential stagflation might ultimately lead to increasing pressure for borrowers to serve debt obligations and lead to increasing defaults. We, however, don’t want to be overly pessimistic: given the shorter-term and floating rate characteristics private lending is, by design, well-equipped to bear a sustained period of high inflation.

Furthermore, as banks reduce their lending activities because of ongoing regulatory capital issues, substantial loan loss provisions due to the pandemic and to an uncertain geopolitical context, private debt funds will continue to play an important role in addressing the imbalance in liquidity supply/demand and helping businesses raise capital and stimulate economic growth. Alternative lending options have increased over the years, with the proportion of investments funded by private credit versus banks drastically flipping over the past decade in favour of private credit.

We do not expect this trend to change as recent European data forecasts a 17.4 percent compound average annual growth over the next 5 years for the private debt industry, and private assets will continue to offer attractive investment opportunities and an appealing risk-adjusted return for investors. Two balancing factors remain to be mentioned: flexibility is currently key for private debt and could counterbalance the fact that, with climbing interest rates, leverage has become more expensive and less companies can afford it.

Market trends

The 2022 KPMG/ALFI private debt fund survey confirmed trends seen in the past. Notably, the Reserved Alternative Investment Funds are steadily increasing, with 45 percent of “regulated” private debt funds being structured as RAIFs (+9 percent compared to June 2021), while the Specialized Investment Fund market share continues to decrease (-7 percent compared to June 2021). We expect this trend to continue in the future, considering that RAIF has the same features and flexibility as SIF, but is less regulated. Only the RAIF’s AIFM is subject to supervision and reporting requirements to its local regulator: the double regulation layer is removed, allowing for a quicker time to market.

The flexibility of the Luxembourg Special Limited Partnership also continues to be appreciated across the unregulated market, with the SCSp representing 85 percent of unregulated AIF debt vehicles. Compared to regulated fund vehicles, SCSp is highly flexible and cost less to set up and operate as they do not require direct CSSF approval, reporting or supervision. This accommodates notably loan origination activity where debts are granted to a limited number of borrowers, which in this case can be done without any CSSF authorisation if the funds do not qualify as an AIF.

On the other hand, unregulated SCSp AIFs can also invest in any type of assets and can market their partnership interest to EU-wide professional investors with a specific passport if they are managed by an AIFM. SCSp remain widely used mainly due to its accessibility and flexibility, and also because they are well-known to investors and promoters.

Adrien Rossion is alternative investment manager at KPMG Luxembourg