At PDI’s first Germany Forum a diverse set of attendees and speakers elicited a colourful debate on the current state of private debt in Germany and further afield.
Germany, more than any other country on the continent, is swimming in liquidity. Many people often point out that post-crisis, Europe is still over-banked. And in those terms, Germany stands out with more than 3,000 banks. In a market like that, it’s always going to be difficult for alternative lenders to establish a foothold.
For real estate, one of the most popular private debt strategies, nowhere is more difficult to invest or compete in Western Europe than Germany because of the open and active pfandbrief market that is available for German banks, Paul Dittmann, head of senior commercial mortgages real estate finance at M&G, told delegates.
And for corporate lending, private debt funds have the buoyant Schuldschein market to compete with as well. Thus German borrowers have decent access to cheap financing.
There are still private debt opportunities to be had though. Private debt lenders can and are stepping into the breach, even in Germany, as banks are simply no longer the one-stop lenders they used to be. As banks retrench in the wake of the financial crisis, cross-border transactions in Europe have halved. Instead of losing a potential client to a domestic competitor, a bank will often partner with a foreign debt provider, reflecting a strategy that existed pre-crisis when the foreign lender was another bank.
German banks are approaching private debt funds, for solutions like bridge financing or longer duration non-amortising debt. Advantages like these, as well as speed of execution, can swing a deal in private debt’s favour, as seen with the growing unitranche market in Germany.
Leveraged buyout financing for private equity firms still dominates the corporate landscape but it’s expected that this will spread into sponsorless transactions in Europe as it has elsewhere. In this market though, private debt lenders certainly won’t make ground without help from Germany’s banks, some argued. The approach to this relationship will lie at the heart of whether private debt can flourish in Germany.
Nurturing relationships with institutional investors will also be important in attracting allocations from the region. There are huge amounts of capital that could be tapped for private debt in Germany, but investors are cautious of new market players. Investors naturally gravitate to the biggest names and debt fund managers, PDI heard. However, the biggest managers aren’t always the best and many argued that niche strategies offer the best opportunities.
Private debt, as an asset class, can be easily misunderstood. Terms like ‘shadow banking’ and ‘vulture funds’ have generated a negative perception, with some within the Bundesbank and BaFin, the German regulator, taking a dim view, PDI heard. As a result, investors need time before they can get comfortable with it, even more so in Germany than in other countries perhaps.
Those in the private debt market though believe that forces beyond the control of market or political sentiment are at work which makes a push into the region inevitable, however small or slow. The weight of capital behind institutional investors seeking enhanced risk-adjusted returns is just too substantial to ignore.
The disintermediation of banks is already underway, and Karl Happe, Allianz Global Investor’s chief investment officer for insurance related strategies, views the opportunity as huge. During a presentation, Happe further illustrated his point with a poll. Biases aside, the audience voted that corporate debt offered the most attractive private debt strategy on a risk reward basis. Speaking on the sidelines later, Happe said he viewed the opportunity as infrastructure debt however.
The strategy is a hot topic in Germany at present and capital constraints on governments could mean that the project finance / private public partnership market may be the best avenue for important infrastructure investment to take place in the medium term, Happe said. The strategy presents the perfect alignment of assets with liabilities, in a market that is potentially worth trillions, he added.
The infrastructure example is a case in point too about the juxtaposition between investor expectations and the reality of the investment climate today though.
Investors like infrastructure debt so much that there are 20 asset managers in the space in Europe now compared to none in 2008. Allianz GI, which has a large dedicated team for the strategy, has funded €2.2 billion in 14 deals since they launched their infrastructure debt fund. However, there is talk in the market of a dearth of opportunities meaning yields are compressing.
And continued price compression in all debt markets – both public and private – means that we are now entering one of the most difficult periods for credit investing post the financial crisis, PDI heard during private discussions.
Investors are quick to ask: ‘how quickly will my capital get deployed?’ In this regard, many view the US as more attractive than Europe at present. Equivalent private debt spreads on a relative basis used to be historically almost 100 to 200 basis points higher in Europe than in the US. Nowadays however European spreads are in most sectors lower than US spreads, said Hans-Jörg Baumann, director at Swiss Capital Group, adding that he believed that on a risk adjusted basis you are better compensated in the US. Also in the US’s favour, is its homogeneity compared to a fragmented Europe, along with its deeper market and bigger pool of more mature and established talent.
During a lively panel, Baumann agreed that on a cross-border basis, disintermediation will grow in Europe. But that for the foreseeable future, the European market does not offer the same deepness of investment opportunities as the US market.
Others panellists conceded that the shift from a bank financed market to a non-bank one will be slower and less pronounced than demonstrated in the US over the last 15 years. But if investors have realistic expectations about the speed of capital deployment and allow managers to be selective about credits – and sacrifice spread for covenants in a less benign environment, as suggested by Symon Drake-Brockman, managing partner at Pemberton Capital Advisors – then the strategy can work.
The fact remains however that many throughout the market are yet to be convinced that direct lending in Europe is scalable. An oversimplification it may be, but investors still worry whether the returns will justify the costs.
Sourcing is paramount to the strategy. And in Europe, private debt’s distance from local markets is one of its biggest obstacles to growth. A broad net, that many choose to cast from London, will help with deal selection.
But Europe is comprised of many jurisdictions. In Germany for example, there is a language barrier to consider, as well as different tax and legislative idiosyncrasies. Sourcing deals can take an enormous amount of resources and proximity to the market is crucial, many agreed.
The regulatory environment is also a high barrier between investor capital and private debt funds. According to one of the panel discussions, taxation and specifically the issue of withholding tax when investing in non-European jurisdictions, is underestimated.
For smaller institutional investors, who are interested in private debt but less resourced than their bigger kinsfolk, a private debt fund manager may need to provide more guidance than is typical during fundraising, to the extent that they may need to provide information and regular reporting in German.
Recent regulation allowing domestic asset managers to lend in Germany will go some way to help support a more positive environment though. Efforts at a Europe-wide level too, such as the Capital Markets Union, will also aim to address the fragmented nature of Europe’s market. The new European Long Term Investment Funds in the works could help investors allocate.
Solvency II is expected to facilitate a more supportive environment for private debt than the exiting regulations, Happe says. Private debt will help investors diversify their portfolios, which should lead to a more positive treatment from regulators in terms of capital requirements, many believe. Asset-liability matching is expected to lower them further.
The ability of institutional investors to create a bucket from their allocation strategy for private debt, for many in the market, is the ultimate goal. As once created, the floodgates could open. Helping investors to create those allocations, particularly from fixed-income buckets, will be an important step in the evolution of private debt in Germany.
A responsible approach to investments meanwhile, will be crucial to the asset class’ delicate reputation.