Private debt and the case for Europe
December 2014 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
Beyond relative liquidity, there exists a clear correlation between the structure and coupon timetables of private debt and fixed income products, specifically in the emergence of direct corporate lending. As a financing option for middle market businesses, the flexibility offered by non-bank lenders is a welcomed alternative to working within the traditional banking system which through the ongoing process of disintermediation has had its hands tied in many areas. The flexibility gained when working with a debt provider versus a bank can drastically speed up the underwriting and financing processes for a borrower as well as offer more favourable loan terms from fund managers ready to deploy dry investment capital.
Direct corporate lending as an illiquid debt fund structure has been the ongoing story within the growth of alternative credit since 2008. Compared to mezzanine and distressed vehicles which have operated in the private equity financing segment for decades, secured is more in line with the risk appetite of the fixed income investor. Large, globally present managers from both the private equity and fixed income worlds have transitioned into the market in the wake of bank deleveraging with ample institutional capital in tow. Sophisticated investors have already deployed dedicated private debt teams to monitor hybrid portfolios of credit assets, and the trend suggests that large pockets of institutional capital are to follow in 2015.
Mezzanine and distressed debt are likely to persist within credit markets though, as situations where such borrowing is necessary continue to exist for investment further down the capital stack. Already having carved out their own corners of the debt market, mezzanine and distressed vehicles are quietly becoming overshadowed by the direct lending market, in terms of growth in both overall capital and total number of funds raised. Exposure to such assets is still integral to many private equity and opportunistic allocations, as these strategies offer attractive risk adjusted returns as integral components of private equity allocations.
The European opportunity
As the deleveraging of European bank balance sheets continues to be driven by pressure from government and regulatory bodies to replenish support funds and recapitalise, the opportunity exists for third parties to generate attractive risk-adjusted returns by acquiring loans and providing liquidity during the foreseeable readjustment period.
The hunt for yield in the low interest rate environment has undoubtedly fuelled the growth of the closed-end private debt fund market, most notably in Europe since 2008, as complex regulation has become effective. Government and corporate bonds once lauded for liquidity and security remain at near historic lows with no clear turnaround on the horizon. It is possible that the growth in private debt exposure and allocation for institutional investors could be fed by those same investors repurposing funds from strategies defined as traditional into new fixed income-like alternatives.
Divestment of both non-performing loans (NPLs) and other non-core assets held by banks as well as new loan activity bolsters the attractive environment for purchasing of assets and alternative financing solutions offered by private credit managers. Pressure from ECB policies to recover funds issued in the form of bailouts can most simply be produced through liquidation of assets throughout the capital structure, from long term covenants to bad debts, which can be worked out by the loan purchaser, rather than sovereignties who would prefer the immediate liquidity. The sale of these assets coupled with an exit from lending activity is the likely roadmap to sustainability for banks and the governments that supported them through troubling economic shifts.
Though granular and specific opportunities will need to be further investigated with an eye on country specific framework and factors, the situation remains attractive overall to the opportunistic investor in the debt space. During the disintermediation process over the next decade, assuming a smooth detangling of assets and definitions of what must be done for banks to recapitalise; investors with infrastructure in place to approach these deals could be in line for successful adoption of private debt strategies. Understanding of regulatory nuance and asset complexity is essential to valuation and unlocking the traffic in the European debt market.
Doug Paolillo is a private debt analyst at Preqin. He can be contacted on +1 (212) 350 0100 or by email: firstname.lastname@example.org.
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