Private debt came into its own after the global financial crisis. But the US market has matured since then, and some domestic managers are increasingly turning their gaze across the Atlantic, where the opportunity for growth in the asset class is still relatively strong.
Although the Blackstones and Carlyles of the world have been building a presence in Europe and elsewhere for years, in recent months there has been a flurry of partnerships announced between Old and New World managers in the more fragmented European market, where rules can change from one jurisdiction to another. Since December, four US managers have joined forces with counterparts in Europe, and at least one head of a firm – Ted Koenig, Monroe Capital’s chief executive in Chicago – continues to hunt for other opportunities.
“Conditions are ripe in Europe for the same type of growth” the US has seen in the past few years, says Koenig, who in March teamed up with Aberdeen Standard Investments’ Bonaccord Capital Management, based in Edinburgh.
Blackstone’s European credit business has doubled its business every two to three years since it began life as GSO Capital Partners in 2006, says its chief, Paulo Eapen, and he expects that trend to continue for the next three to five years. Blackstone Credit in Europe now deploys $5 billion to $6 billion a year, surging from $1 billion to $2 billion a year just five years ago.
“We definitely think that having devolved decision-making with a senior local team
Small wonder then that in December New York Life Investments Alternatives, alongside its European-based affiliate, Candriam, inked a partnership with pan-European firm Kartesia, while Churchill Asset Management, an affiliate of Nuveen, and Paris-based Tikehau Capital agreed to invest in each other’s funds. In February, Bain Capital Specialty Finance formed a direct lending joint venture with London-based Pantheon.
“The tailwinds in the European market are quite attractive, and the expansion of partnerships overseas is also a reflection of the highly competitive market in the US,” says Christopher Taylor, head of New York Life Investments Alternatives and CEO of its subsidiary, Madison Capital Funding.
Mark Jenkins, managing director and head of global credit at The Carlyle Group, which has been global for decades, says that because Europe represents the equivalent of less than one-third of the US market in terms of size, there is plenty of runway for growth. “Having on-the-ground experience is relevant because, for example, the typical US bankruptcy rules don’t apply,” he says. In such cases, “it’s important to understand how to resolve issues when things go wrong”. Having a local presence also is critical to finding and underwriting deals.
Eapen notes “a lot of fundamental differences in each European jurisdiction” and only a handful of firms, like his own, that can say they have transacted and structured over the last 15 years across all of Europe and been successful. Although Blackstone has a well-established European credit business, Eapen says he understands the attraction for other US-based firms to partner up with smaller European funds to access the nuanced regional execution experience.
Taylor says that because each country has different local dynamics, and because of regional registration requirements, “it would be very challenging for a US manager to build a presence in Europe and not have a pan-European footprint”.
US and European managers “can date and not get married”, says Kenneth Young, co-head of private equity at Dechert. Conversely, “non-US investors do not have to worry about filing a tax return in the US”, says Thomas Friedmann, managing partner of the law firm’s Boston office and co-chair of its global corporate finance and capital markets practice.
European loans ‘complex’
Furthermore, originating loans in Europe is “a little more complex”, Taylor says, because managers must source from multiple channels, including companies, sponsors and intermediaries such as investment banks. The US direct lending market, he says, is “probably more of a straightforward model”, where private credit managers are primarily sourcing opportunities directly from sponsors.
The European market has been evolving and opening up more to private lenders and private credit managers, with banks “increasingly taking a back seat to a lot of lending they would have historically done”, says Greg Myers, global segment head of debt capital markets at Alter Domus, a large fund administrator. That creates opportunities for veteran US managers.
“The tailwinds in the European market are quite attractive, and the expansion of partnerships overseas is also a reflection of the highly competitive market in the US”
Madison Capital Funding
There are benefits for European managers too. “As a partner, we’re providing introductions and access to a broader investor network,” says Madison Capital’s Taylor. However, he expects the European market to continue to mature over the next few years. “The next frontier we’ll be looking at are new geographies such as Asia.”
According to Carlyle’s Jenkins, “if you are a large global asset manager like us it makes more sense to look at Asia”. China is particularly attractive, he says, because “as growth rates slow, companies will have to be more balance-sheet-focused and not look solely to equity markets to finance growth”.
Whatever the case, the hunt for yield in a low interest-rate environment will continue to unite investors around the world. Says Taylor: “I anticipate a continued trend of globalisation of private credit as an asset class.”
John Bohill, a Dublin-based partner at investment and advisory group StepStone, says consolidation, fragmentation and specialisation are phases markets go through – “ebb and flow”, as he describes it. The emphasis now is on consolidation as investors gravitate to larger managers, which then have greater scale when it comes to raising capital, deploying it and monitoring investments.
Once there is sufficient scale, managers have important decisions to make about how best to expand. One option is to grow over the other side of the Atlantic. “So then you get large managers investing in both regions,” says Bohill. “That allows them to talk to investors about their options across the two regions and you can have a relative risk and return discussion and offer investors a more nuanced portfolio.”
The pandemic has favoured consolidation, he says, since “the groups that had large diversified portfolios through covid were somewhat insulated from difficulties. Smaller firms which had concentrated exposure to more exposed sectors maybe struggled a bit. There was a perception of strength in numbers and that’s attracted capital to the bigger players.”
Bohill points to numerous strategic partnerships formed over the years in private debt between North American and European groups, including between British Columbia Investment Management Corporation and Hayfin, Brookfield and LCM Partners, and Bank of New York and Alcentra. He is not surprised at the current trend for these types of partnerships over organic growth, partly because ‘going organic’ can raise organisational issues.
“We definitely think that having devolved decision-making with a senior local team is better,” says Bohill. “You might have a European team originating transactions and they get on the phone every week recommending deals to a New York-based investment committee who don’t really have a connection with what’s happening on the ground, but the local team can’t decide for themselves. That’s not a sustainable situation.”
There have, however, been plenty of firms looking to take a do-it-yourself approach to regional expansion. London-based fund manager Park Square Capital launched a New York office in 2014 and now has a substantial team there. Hayfin has also made significant inroads in the US, particularly in structured finance and collateralised loan obligations. In the other direction, US managers such as Golub Capital, White Oak Global Advisors and Owl Rock Capital (which recently merged with Dyal Capital Partners to become Blue Owl Capital) have all been making moves into Europe.
Abhik Das, managing director and head of private debt at Munich-based fund of funds manager Golding Capital Partners, says investors will want to carefully examine the motives for such moves. “As an LP, you would be asking yourself whether it amounts to asset gathering, building an empire and all about increasing the value of the GP,” he says. “But the managers will argue that they have a number of sponsors that like to work with them and these sponsors want them to have a presence on the ground.”
“European investors are really ahead of the game on ESG and as ESG becomes more important to investors [in Europe] it might create a barrier to investing in the US”
Das can see the merits of going global: “You’ve always had mezzanine funds from the likes of Goldman Sachs, HPS Investment Partners and KKR operating globally, or funds like Park Square expanding from Europe to North America, which may have been driven by necessity when the European market did not offer enough opportunities. To have the possibility of playing across the US, Europe and Asia-Pacific can be beneficial from an LP perspective.”
One major consideration in expanding regionally is that, for European
institutional investors and US fund managers, crossing the Atlantic to make debt investments can be challenging and costly. Although physically crossing from the Old World to the New might be relatively simple, the pandemic notwithstanding, moving capital is fraught with tax and regulatory issues that must be successfully navigated to generate returns.
The biggest issue for any European institution looking to diversify its portfolio by adding North American debt is avoiding a large tax hit as a US lender.
In a 2019 report, investment consultancy bfinance warned that international investors in US private debt funds were facing hidden costs that could erode returns by up to 5 percent. High taxes have been a major historical factor facing non-US investors, and so the industry has sought to develop innovative fund structures to make US debt funds more appealing to international LPs.
‘Season and sell’
However, bfinance senior director Trevor Castledine says: “For a European investor wanting to diversify into US debt funds there is always going to be a cost involved as you are replacing taxes with other risks.”
According to Castledine, the “season and sell” approach has been one of the most popular methods European investors use when investing in US-based funds. It involves originating loans via a US entity, which are then purchased by non-US investors. However, Castledine is uncomfortable with this route as the Internal Revenue Service could take a test case against it, leaving investors exposed to US taxes. “Another approach is to set up an offshore vehicle,” he explains. “In this case you have to accept it is going to be subject to US taxes, but the investor itself is sheltered from taxation.”
Offshore vehicles will typically use leverage to help increase their overall returns and thereby cancel out some of the additional taxes they will face. However, this makes some European investors uncomfortable.
“US funds are often leveraged and this has not always been to the taste of European investors,” Castledine says. “But leverage for debt may now be more palatable as the asset class has proved to be very robust during the coronavirus crisis and I think more European investors should think about investing in leveraged funds.”
A final route for those looking to invest across the Atlantic is through insurance companies. An insurer is able to hold assets on behalf of an investor and then issue it with an insurance product. This has the benefit of shielding the investor as it does not hold any of the actual assets, making the product more akin to a derivative. However, insurers charge a margin for this service, which can make it relatively expensive for LPs.
It is also worth considering the adverse effect of covid-19 on transatlantic investment activity, largely due to travel constraints.
“During the crisis it has been tricky for investors to onboard new managers,” says Castledine. “Many face internal rules around due diligence which require face-to-face meetings.”
Should LPs mix the US and Europe, or go global?
Joe Abrams, European head of private debt at Mercer, says his consultancy has many conversations with investors about whether to make commitments to a selection of US and European managers and blend them into a portfolio or commit to global teams. Given that, in credit, potential return distributions are skewed to the downside, he notes that diversification is always paramount. Allocating across geographies and sectors, and then of course manager selection, are critical. However, there can be opportunities within the asset class to assess relative value. “People have taken notice of an opportunity to do so,” he says. “However there are limiting factors around this such as liquidity and governance, which is why it is likely achieved best by an asset manager with global reach and resources, although these are few and far between.”
When it comes to global capabilities, Abrams says how decisions are made within organisations is a crucial factor: “Figuring out how decisions are made is part of our due diligence and, if the investment committee is far away from where the deals are being done, that jumps off the page. You have to be really close to the ground in Europe because of the cultural and linguistic differences and the different legal jurisdictions.”
Remaining in place
With international travel unavailable or restricted, some institutional investors have been forced to reinvest with their existing managers instead of considering whether changing to a new manager might be a more optimal way to deploy available capital. However, Castledine adds that the crisis has not fundamentally ended the desire among larger investors that need to diversify their portfolios geographically to commit capital to US managers.
A final area of difficulty for those looking to access the US market is the country’s markedly different approach to ESG investing. “European investors are really ahead of the game on ESG and as ESG becomes more important to investors [in Europe] it might create a barrier to investing in the US,” says Castledine.
“There is a smaller population of US managers who believe ESG is important and this gives rise to the question of whether the US is really investable from an ESG perspective.”
It is unclear whether President Biden will seek to enhance ESG requirements in the US, though he has taken a stronger line on environmental issues than his immediate predecessor.
For many investors it may be simple enough to pursue local managers, invest or access US private debt investment expertise through Europe-based funds and partnerships. However, those who seek to invest directly into North America now have a wealth of options about how they might do it. They must nevertheless bear in mind the complexities of accessing a very different regulatory and tax environment.
Andy Thomson and John Bakie contributed to this report