Today, the European private debt market is seeing significant sums raised for strategies that are more opportunistic in nature. Investment parameters are now broader and more managers are commingling their privately originated mid-market opportunities with large cap issuers in the syndicated loan and high yield market. This allows managers the flexibility to take advantage of market dislocation in public and private markets and enhance overall fund returns on a total return basis. This broadening of investment strategy will lead to a requirement for a more robust and integrated offering from service providers between fund accounting, middle office, collateral administration and loan agency.
Virtus Partners evolved from its roots in syndicated bank debt to an end-to-end turnkey provider for private debt managers by bringing together a technology-enabled middle office platform, a complete loan agency offering and a fund administration group with significant experience in credit markets. The idea is that an integrated offering, deep asset class knowledge and technology orientation can help clients deal with complex strategies and provide a scalable architecture for managers to utilise, as needed.
Bank debt itself has long been one of the most challenging asset classes for fund administrators given its many idiosyncrasies. Having investment buckets allocated to syndicated debt within an otherwise illiquid portfolio presents challenges for service providers who do not have familiarity with the asset class. Outside of senior debt or capital opportunity type funds, most medium and large-sized managers are now set up as multi-strategy platforms: from liquid to illiquid, performing to non-performing, with various underlying collateral, tiered by target return profile and attracting an ever-broadening type of institutional investor.
For these types of managers there is a need for providers who can handle all aspects of middle and back office workflows across all strategies, allowing them to focus on core areas of origination, underwriting, trade execution and monitoring. A long-term strategic partnership with Citibank Agency and Trust has allowed Virtus to service the largest credit-orientated managers in the market. This partnership has also given us a look into the financing landscape as it relates to mid-market private debt funds.
Whilst it has been common to see capital calls, subscription or bridge facilities used in these types of funds, permanent leverage was highly dependent on the fund manager, the strategy and relationship with underlying fund investors. Along with a substantial change in the active bank participants in this market over the last 12 months, the other key development we have seen is the convergence of structured finance technology with more traditional fund finance facilities.
Traditional fund finance facilities typically were established under a standard LMA form facility agreement in a newly created special purpose vehicle as per a normal warehouse phase for an asset-backed securitisation deal. The borrower and lender then agreed standard criteria: borrowing base, advance rate, covenants, events of default etc. Credit funds consisting of a portfolio of senior loans with predictable cashflows characteristics have always been well suited to taking on leverage. The increased need for permanent leverage in mid-market direct lending funds is now leading to structures being offered by bank desks that are in essence private CLOs – with increased focus on the borrowing base and other CLO-like portfolio tests.
Whilst these financing structures can mean they have then to comply with enhanced regulatory oversight, and have a suitable entity that retains a 5 percent material net economic interest in the commitment, managers are taking the view that this hybrid loan facility/private CLO is worth the effort in order to obtain higher leverage levels, thus allowing them the potential to achieve higher overall levered fund returns. Virtus has experience in administrating such facilities given its strengths in the structured/warehouse market and is currently working with several mid-market direct lending managers in Europe providing collateral administration, borrowing base calculation, cash management and compliance test monitoring services.
Following historic developments in adjacent illiquid asset classes such as private equity and real estate, we believe LPAs governing private debt funds will continue to become increasingly bespoke with individually negotiated contractual provisions between the GP and LPs in turn necessitating an outsourced provider who can deal with such complexity and isn’t set up to only administer plain vanilla funds with no SMA side-by-side structures, straightforward allocation methodologies and back-ended waterfall arrangements.
Whilst almost all larger credit managers have the internal knowledge and experience within their CFO/Fund Controller teams to fully appreciate the challenges of their own fund LPAs and key fund terms open to interpretation, some of the newer startup private debt managers that have launched in the past 18 months prefer to focus more on obtaining a comprehensive end-to-end outsourced financial reporting and administration solution at the lowest possible price.
In order for many of the larger asset managers to fully embrace outsourcing they will need to have confidence in their service providers. As ever, Virtus believes technology will be a critical enabler of the transparency needed – where waterfall cascades can be modelled in a transparent manner from service provider to CFO/Controller – allowing real time interactions and discussions to take place making the overall relationship one of partnership rather than that of manager/service provider.
Finally, the last area we believe managers will increasingly look for an integrated outsourced solution to overcome operational challenges in private debt is in the area of loan agency. Three factors in our opinion will drive this trend:
(1) Managers who have traditionally fulfilled this role in the past are now reaching the point whereby their internal infrastructure cannot keep pace with their levels of ongoing origination activity. The level of event management, document co-ordination and cash management needed for each facility can be substantial, needing dedicated resourcing and technology investment.
(2) As we enter the latter stages of the credit cycle, it is likely that the coming years will see significantly more “special events” such as steering committees, events of default, complex restructures and distressed workouts occurring that will highlight the need for a capable loan facility agent that understands all the angles and are cognisant of their fiduciary duty in this capacity.
(3) As recent market litigation has shown, there will be a need for a truly independent and non-conflicted loan agent to administer syndicated, bi-lateral, club and direct loans going forward in this market. Using the latest version of Misys Loan IQ, Virtus is able to deliver a complete service to all parties concerned in lending transactions in the private debt space.
Confucius said: “Life is really simple, but we insist on making it complicated”. The European private debt market is now firmly moving down a track that many other segments of the alternative asset management industry have travelled as it continues to evolve. With this increased complexity, there will undoubtedly be a requirement for a partner that not only has the asset class knowledge and infrastructure but can truly be a one-stop shop offering a multitude of integrated services.
Dermot Caden is senior director of European fund services at Virtus Partners. With more than $250 billion of assets under administration, Virtus combines service and technology to provide a range of solutions for alternative asset managers including fund accounting, middle office services, collateral administration on structured deals and loan agency services. Virtus’ clients are served by more than 300 employees located in Houston, Austin, New York, Shanghai, London and Dublin.
This article is sponsored by Virtus Partners. It appeared in the Fund Administration and Corporate Trust Guide published with the February 2017 issue of PDI