“It is in everyone’s interest for the UK’s exit to be managed calmly but swiftly,” Valdis Dombrovskis, the European commissioner in charge of finance services said in February.
The comment, made at the annual European financial services conference in Brussels, is a shift in tone from the diplomatic bluster we have heard from both sides of the English Channel in the nine months following the UK’s vote to leave the EU. But it’s a recognition that the now seemingly tedious task of negotiating the exit is about to begin.
So what should the private debt market watch out for? Top of many fund manager’s lists is an AIFMD passport, a key right in enabling funds to market investment products across all EU member states without permission from each national authority.
Because many private debt funds have their European headquarters in London, especially those based in North America, there are big questions over their fund’s operations if the UK does not obtain such a right. Whether they open offices, shift staff to Frankfurt or Paris, or remain in London may depend on whether the European Commission extends the right.
UK Prime Minister Theresa May has said she will prioritise restrictions on freedom of movement over access to the single market, rights that go to the heart of the foundation of the EU and are inseparable, according to European lawmakers. For the EU, access to the single market requires nation states opening up their borders.
Other key considerations for the private debt market post-Brexit will be issues on trade and immigration and there is a two-year countdown to work this out once Article 50 is invoked. Nine months on, however, there appears to be no clarity on any of these issues.
Nevertheless, the fertile conditions that fostered the growth of the European private debt market remain intact and the resulting disruption over the question of Brexit could continue to not only highlight the positives of the asset class compared with other investment products, but demonstrate its robustness over a tricky economic period. Daniel Roddick, who runs the placement business for EPIC Private Equity, notes: “There is still a compelling case for private debt.”
Bank of England governor Mark Carney was thrust into the spotlight after announcing a further cut in interest rates to a historic low of 0.25 percent.
Investors already unloading government bonds over the last several years in search for yield had a bigger incentive to pile into private debt funds. “There is a greater portion of investors’ portfolios going into private debt, and if interest rates remain low then the asset class will continue to be attractive for those in search of yield,” Roddick says.
For the pension funds and institutional investors, allocating more from the fixed income portfolio to private debt works because liquidity is not such a huge issue. These investors are able to lock up their capital into low risk strategies over a longer period. The relatively benign credit environment meant there were few cases of defaults.
Combined with the banks’ withdrawal from mid-market lending, private debt funds were having success providing senior and mezzanine corporate loans. Bigger funds were raised and more capital was being put to work. Sensing the tide was turning, banks started to partner up with funds free from capital requirement regulations.
The increasingly competitive nature of the corporate lending market has put pressure on fund managers to generate the returns investors are seeking. “Corporate lending has become more competitive which has certainly had an effect on pricing. Investors are also worried that GPs are taking on riskier deals at higher leverage multiples in their need to maintain target returns,” says Roddick.
An increasing concern among investors is that the private debt market is overcrowded. As sponsorless strategies continue to be only a small fraction of the market, many fund managers rely on the networks of private equity firms, advisors and banks to source their deals. And that trend has pushed many investors to look at more specialised strategies over the last nine months.
One asset class benefiting from this trend is real estate debt, says Paul House, managing partner at Venn Partners. “The real estate debt market is reaching a new maturity and came into the mainstream in 2016,” he says.
ICG-Longbow, the property investment arm of ICG, hit its hard-cap of €1 billion, raising a handsome €146 million in the months following the vote. Aalto Invest, a platform established by former banker Stephen Eighteen in 2013, was acquired by Man Group as part of the hedge fund’s strategy to gain exposure to this growing market – two notable successes from 2016.
Within the UK there has been a shift towards renting in the UK as people struggle to get onto the property ladder. Responding to this trend, Venn, in partnership with the UK government, issued two bonds to finance loans made through the Private Rented Sector (PRS) guarantee scheme as a way of channelling institutional capital to the market.
“There is a chronic under supply of housing in the UK and the government is encouraging the development PRS schemes professionally managed by institutional operators. It’s a defensive asset and less volatile and is gaining interest from investors,” House says.
However, he notes: “The need to educate investors on PRS continues as the asset class develops.”
Brexit has also forced many investors to rethink their geographical allocations. Where Britain’s relative regulatory openness and stable political environment had made it attractive, the recent turmoil has meant many pension funds and insurance companies have had to rethink their approach.
Galeazzo Scarampi, a partner at Italian asset manager Quadrivio, says Italy is generating more attention. “There has been a noticeable increase in interest around private debt in Italy during the last nine months, although it is hard to single out Brexit from other factors.”
The increasing visibility of private debt to borrowers and gradual relaxing of regulations have added to Italy’s attraction as a destination for private debt investments, adds Scarampi.
The hyperbole from both sides of the referendum campaign suggested that the world would end if voters made the wrong choice. And like all end-of-the-world predictions, it has fallen flat. What has occurred, however, is a radical rethink of investment strategies and fund managers will need to take note of these trends.
But what now begins is the arduous task of negotiating a new arrangement between the EU and the UK, where passport rights, trade and immigration are all up for debate. No matter what the outcome, one can only hope it ends calmly and swiftly.