The private debt funds market is growing quickly in Europe and there’s more to add, commented a panel at last week’s ALFI Global Distribution Conference. The panellists discussed the attractiveness of this sector in general, particularly to the insurance industry. They also looked at where the market is headed, and why Luxembourg has emerged as the leading hub in Europe.
Assets under management in European private debt funds are at about $315bn (€271bn, out of a European total fund market of €20.6trn), said panel moderator Nicolas Bouveret, a partner with Arendt & Medernach. This puts this asset class at about the same size as the real estate fund market which is about a third as large as the private equity space. He noted that Europe’s investment in this relatively young market is around half that of the US, hence the general optimism that this is a growth sector.
Growth phase
Marco Verheijen, senior investment manager private & public markets with the Netherlands-based insurance company Athora, was bullish. He cited “high returns and lower volatility due to the less frequent valuation of the assets” as being attractive features of private debt investment. Nevertheless, “caution is required” as we emerge from the pandemic, he added.
Alex Walker, managing director at private debt fund Alcentra, said he also saw positive signs, with investors being more comfortable with the asset class than they were 8-10 years ago. They no longer need explanatory conversations, and “it’s more about dynamics of the market, different credit performance and market trends, differences between geographies,” he commented.
Advantages for institutional investors
The specific advantages for insurance institutions of debt were commented upon by Verheijen. “We benefit from lower solvency to capital charges,” he said. “If the underlying credit were to be rated externally, this would be at around a low double B profile for an average private credit portfolio. But as these loans are typically unrated, the capital charge under Solvency II is more equivalent to a triple B corporate rating,” he said.
As well investors “benefit from additional income, such as the fee that traditional came with the origination and the structuring of the transaction,” he said. Historically banks earned the entire set of fees from syndicated loans but now, with direct lending, the origination fees in whole or in part are shared between the direct lenders and their investors. “The original issue discount for example, can be one to two points or other income could be an additional one to two points,” he said.
What strategy?
Bouveret said he sees a market where investment strategies have proliferated. Initially the focus was on direct lending mid-market strategies, “but then quickly expanded into a whole variety of other strategies, mezzanine, special situations, distressed debt, opportunistic funds, even real estate.”
So how does Athora decide on asset allocation between various types of strategies? “We try to identify the return drivers. Like how high is the coupon? Is it worthwhile taking the incremental credit risk in a capital structure? We look at LTV (loan-to-value) metrics.” He also cited the importance of the external manager having a decent track record.
This has led to some of the bigger names in the sector attracting increasing attention. “We also see that there’s a so-called grey space where a borrower could choose either to lend from a direct lender, like KKR, CVC, or they can choose to go out to the broadly syndicated market,” he commented.
Flexible structuring
As for structuring, the panel agreed that no one size fits all, and there is need to adapt to the needs of investors. “Luxembourg has been very successful in attracting private debt funds” Walker said, because “there are structures that allow us to lend into the various European geographies without regulatory or tax issues.”
“From an investor perspective, there are attractive and familiar structures which allow us to design the final product that investors were like. I think like most managers, our market is global, so we need vehicles that are familiar to investors from multiple geographies,” he added. He cited the limited partnership or the reserved alternative investment fund (RAIF) structures offering this flexibility.
“We can say that private debt is really here to stay as a valid alternative to the liquid credit product without replacing it,” said Bouveret. Debt provides the return risk and return profile that that institution investors are looking for in the current environment.