Q: Why are insurance companies more restricted than pension funds in investing in private debt?
Declan: The Solvency II Directive restricts the nature of investments that can be made by insurance companies. Pension funds have more flexibility.
Q: Can you tell us what changes you see in regulation of insurance companies investing in private debt?
Hans: Under the current regulatory investment restrictions for German insurance companies (so-called ‘Investment Ordinance’), investments in closed-end loan funds are the only eligible ones under the quota for private equity funds. Although certain self-origination loan funds or mezzanine funds qualified, other passive funds (for example by acting through the syndicated loan market) were not eligible investments.
According to a draft [revision] which is expected to become effective in the near future, the investment universe for German insurance companies will become more flexible. Accordingly, it is suggested that a new ‘Alternative Investment Fund’ quota of 7.5 percent will be introduced. This will cover any investment in closed-end funds, provided that the fund and its manager are AIFMD compliant.
Although in principle this is good news for this asset class, the downside is that any offshore or non-AIFMD compliant fund would not be eligible. Typically, we will see German insurance companies invest in Irish or Luxemburg fund structures as a result.
The proposed change to the Investment Ordinance is [also] expected to introduce a more flexible quota for direct secured loan investments of up to 5 percent which should also be helpful with respect to managed accounts.
Other investment structures remain a viable alternative. This includes setting up a managed account – eventually through a German ‘Spezialfonds’ for which the loan fund manager acts as a delegated portfolio manager or using structured notes issued by Special Purpose Vehicles investing into loans. We have recently implemented both structures for German insurance companies.
Q: What changes are happening in Europe?
Hans: There have been concerns over Solvency II, the incoming European regulation applicable to all European insurance companies, which establishes new minimum risk capital requirements for insurance investments.
In the case of a debt fund, the concern was whether the rules would apply to the underlying assets or the shares of the fund. Basing the capital assessment on the underlying assets, would, in principle, allow for a lower charge. Approaching it from an investor point of view, the equity investment in the fund would trigger a higher solvency capital charge.
According to recently published technical standards on the interpretation of capital charges under Solvency II, it is now clear that the charge is based on the underlying assets. This, however, requires that the debt fund is transparent about its underlying assets and provides ongoing Solvency II reporting to its investors.
We expect that debt fund managers will be asked by European insurance companies to provide Solvency II reporting. From a macro perspective the introduction of Solvency II should create more interest from insurance companies in investing in the private debt market, compared with the (unlisted) equity market.
[Solvency II rules] will start to apply early next year. They will be fully applicable from 1 January 2016. In a nutshell, we see both developments as positive for debt funds.
Declan: Ireland has recently introduced a loan origination fund regime and similar regimes are in place in Luxembourg and Malta.
Q: What in your view is driving these changes?
Declan: Solvency constraints for banks and Solvency II for insurance companies is driving the demand for other options to plug the ‘funding gap’, as described by ECB president Mario Draghi.
Q: Do you know of any figures that quantify how much insurance company investment in private debt could be worth?
Hans: If you take as an example German insurance companies, total AUM is about €1.3 trillion, of which traditionally more than 80 percent (directly and indirectly) was invested in the (public and private) bond and debt markets. Hence, this investor class is potentially a substantial investor in private debt.
Hans Stamm is a partner in the Munich office of Dechert LLP. For more than 20 years he has advised on private funds and structured financing transactions. Declan O’Sullivan is a partner in the Dublin office, advising domestic and international clients in the establishment and authorisation of all types of investments funds.