Future of private debt: Alter Domus on regulation

Max Dambax alter domus 180

Maximilien Dambax

While the European lending landscape is gradually beginning to change shape, alternative funding sources available to small and medium-sized enterprises (SMEs) and start-ups remain fragmented.

Bank loans are still the main pillar of debt funding, yet disintermediation, where corporations obtain debt funding from non-bank sources, is broadly gaining ground as ongoing regulatory pressures continue to constrain lending activity. This reduction in lending has been a clear trend since the global financial crisis and, as banks retreat, private debt fund managers have emerged to bridge the gap.

In 2015 the private debt asset class passed a significant milestone with assets under management (AUM) in excess of $500 billion according to a new Prequin survey. This placed private debt AUM third behind buyout and real estate strategies but ahead of venture capital and infrastructure.

While some 80 percent of loans in Europe are still provided through the dominant banking channel according to McKinsey Global Institute and the Group of Thirty’s latest study, there is a clear trend emerging. Private debt funds are now firmly recognised as longer-term business partners, supporting businesses with long-term financing solutions structured and tailored to meet individual needs and to better help companies achieve their objectives.

ALTERNATIVE LENDERS: FROM THE SHADOW TO THE LIGHT

European regulators and banking authorities face a major dilemma: how to foster the required financing for borrowers while simultaneously ensuring banks deleverage, reduce drastically their balance sheets and reprice the cost of credit. A recent European Central Bank (ECB) survey shows that mid-market corporates reported a reduced supply of bank loans for the fifth consecutive year despite extraordinary measures by the ECB with its Long Term Repo Operations.

Money is still not flowing to the critical SME sector, the backbone of the European economy in that it creates 85 percent of new jobs. With Europe’s economy still so heavily reliant on bank funding, especially compared with the US, a capital markets solution ready to provide the necessary liquidity has not yet been established. Instead, the market saw the rapid rise of private debt funds jumping on the opportunity to fill the gap left by retreating traditional banks.

Through the Capital Markets Union (CMU) action plan, the European Commission issued a clear statement to see greater diversity and improve access to funding in general and more especially alternative forms of financing available for European businesses and SMEs in particular.

At a time when banks are in retreat, private capital for funding businesses is growing increasingly important. In addition to the attractive yields it offers as an asset class, the EU has turned its spotlight on the existing regulatory framework surrounding loan origination. But this attention, with regards to any future regulatory framework, does not necessarily mean a greater burden but could be seen as an opportunity to further enhance the development of the private debt market.

While some countries have clear structures in place for originating and holding private debt in alternative investment funds, other EU countries are not only moving at different speeds but in some cases in different directions.

According to the European Securities and Market Authority (ESMA), certain countries are permitting:
– Loan origination by Alternative Investment Funds (AIFs) with restrictions and a specific legal framework.
– Funds to originate loans but not as the main activity of the fund.
– AIFs to originate loans but with no specific legal framework for the activity.
– And some are not permitting AIFs to originate loans in their jurisdictions.

What we are seeing today is the emergence of different frameworks for loan origination across a range of jurisdictions. In April 2016, in response to a request from the European Commission (EC), which is assessing if there is a need for greater uniformity, ESMA published an opinion suggesting further harmonisation was required. This in turn sparked a debate, or indeed concern, that there are more layers of regulation on their way.

Despite confusion, some key points are emerging from the ESMA recommendation regarding Loan-originating AIFs in:
– Being set-up as closed-ended vehicles without redemption rights on a regular basis.
– Not having liabilities with a shorter maturity than the loans granted by the fund.
– Having a suitable risk management framework to provide credit.

Finally, ESMA also recommends that the Commission review whether or not there should be an authorisation gateway requirement for loan origination funds to better assess the debt fund manager’s capability and project feasibility but also to seek additional protection for both borrowers and investors across Europe.

MOVING TO THE MAINSTREAM

While this increased level of scrutiny of an area traditionally regarded with some suspicion has put asset managers in a ‘wait and see’ position, it does bring a number of benefits. The positive change in sentiment toward alternative lenders, the so-called ‘shadow bankers’, is opening up opportunities for SMEs and institutions alike. For pension funds and insurance companies, it provides a level of protection, and return, to meet their needs while start-ups and SMEs have easier access to finance for long-term investment and structuring.

WHAT’S NEXT?

Simply based on the fact that a debate is happening, it is helping to push the private debt market more mainstream, which in turn will help drive both growth and understanding of its changing role in the investment universe. We are only in the early stages of a conversation that needs to be held, one that stems directly from the global financial crisis.

While regulations can be a burden for the private debt industry, they can also have the positive effect of endorsing the activity by creating a framework that ensures best practice and helps open discussions with SMEs. While further analysis is needed, clearer guidelines and a drive to better inform those private debt initiatives will bring much-needed clarification to this increasingly important asset class.

Where this conversation leads is still not clear but it is arguably now the time for fund managers and the alternative fund community to make their voices heard. We are in a stage of regulatory arbitrage and it is essential to find the right path forward to help drive economic growth and job creation across Europe.

Maximilien Dambax is head of debt administration services for Alter Domus.

Alter Domus is a leading provider of Fund and Corporate Services, dedicated to international private equity & infrastructure houses, real estate firms, private debt managers, multinationals, capital markets issuers and private clients. Our vertically integrated approach offers tailor-made administration solutions across the entire value chain of investment structures, from fund level down to local Special Purpose Vehicles.

Founded in Luxembourg in 2003, Alter Domus has continually expanded its global service offer and today counts 31 offices and desks across five continents. This international network enables clients to benefit globally from the expertise of more than 900 experienced professionals active in fund administration, corporate secretarial, accounting, consolidation, tax and legal compliance, depositary services and debt administration services.

We are proud to serve nine of the 10 largest private equity houses, six of the 10 largest real estate firms and three of the 10 largest private debt managers in the world.

This article is sponsored by Alter Domus. It appeared in the Future of Private Debt supplement published with the October 2016 issue of Private Debt Investor.