Tue, 01/07/2014 - 12:55
Last year, 26 out of 32 specialised funds, designed to invest in small and mid-sized enterprises (SMEs) and provide a much-needed alternative source of funding, launched to invest in Europe. This would suggest that Europe represents a significant opportunity for asset managers and shows that the loan and private debt market is really starting to build traction.
These (typically) closed-ended vehicles now account for 40 per cent of the funds dedicated to financing European companies.
At least that is according to a report released this spring by Bologna-headquartered Prometeia; a 400-person consulting company specialising in business consulting, risk management, financial advisory and economic research.
The firm conducted an in-depth analysis and benchmark of the evolution of the bank loan and private debt funds market in the US and Europe. A total of 152 asset management companies were included in the research, running 186 funds – the analysis focused on funds launched between 2011 and late 2013 – and with approximately EUR110bn of capital, either deployed or with the potential to be deployed.
Although not huge, that figure is likely to rise over the coming years as private equity and hedge fund managers, as well as more generalist asset managers, develop new products and, potentially, lead Europe into becoming more like the US where institutional capital is far more prevalent in funding corporate America.
Indeed, whereas only around 20 per cent of funding corporate America comes from banks, in Europe it is around 80 per cent; a significant structural difference.
As a result, European SMEs are struggling to find the necessary funding as banks continue to deleverage, strengthen their balance sheets to comply with Basel III and reduce the number of loans being made to the market. Bank loans made to non-financial companies in Italy fell by -6.1 per cent in 2013. In Spain that figure was -14.2 per cent, with the Eurozone as a whole reducing bank loan issuance by -4.3 per cent.
“In Italy, over the last 12 to 18 months there’s been tremendous interest in the asset class due to changes in regulation, which now allow SMEs to issue bonds using the same rules that are in place for listed companies,” says Claudio Bocci, senior manager at Prometeia and head of consulting to asset managers, when explaining why Europe’s private debt fund market is starting to expand. This particular sub-asset class is referred to as the ‘mini-bond” market.
“As a result, the loan and private debt fund space has seen growing interest among asset managers and institutional investors. Month on month we’ve seen intermediaries design and start to launch specialised funds within this asset class,” continues Bocci.
Gianmatteo Guidetti, manager at Prometeia and also a co-author of the report, says that the level of interest is spread across Europe: “There are financing pressures facing SMEs all over Europe, and there’s a clear need to find alternative funding channels to banks.”
European banks will need to offload approximately EUR3.2tn in assets by 2018 to comply with Basel III according to a Royal Bank of Scotland report last August. This is providing fertile ground for the region’s nascent private debt market.
Last year, for example, BlueBay Asset Management raised EUR800m for its inaugural direct lending fund while Chenavari Credit Partners LLP manoeuvred to put USD1bn to work in its European direct lending funds.
In the UK, the M&G UK Companies Financing Fund 2 (‘UKCFF2’) is a GBP500m fund that provides senior debt finance directly to mid-sized UK businesses with the UK government’s treasury department and large pension funds all key investors.
Although early days, as the tectonic plates within Europe’s market shift its private debt market will mature and deepen, bringing opportunities to generalist asset managers as well as specialists (hedge fund managers); not to mention institutional investors keen to find alternative sources of yield in today’s low interest rate environment.
“They are looking for new sources of returns as well as diversification drivers. Loan and private debt funds are not only a welcome product evolution in Europe, they are providing valuable support to European economies,” says Guidetti.
For countries like the UK and Germany, a large portion of their economy is driven by corporates with substantial market capitalisation. Accessing global debt and equity capital markets is not an issue and as Bocci says, “there’s less of a systemic funding issue. In countries where the proportion of SMEs is larger (e.g. Italy and Spain) there’s much higher reliance on bank financing. That’s why more intermediaries and asset managers in Europe are looking at this market.
“There’s also a big due diligence cost to institutional investors – if they want to allocate USD500m to corporate bonds then SMEs are never going to be a target. There’s no way an investor would allocate USD2m to 250 different companies. Specialised funds in bank loan and private debt markets provides a viable alternative.”
When it comes to investors thinking about loan and private debt funds they should be aware of the differences in average fund size. Within the asset class, Prometeia divided fund products into the following sub-asset classes:
• Loans (banks)
• Loans (mid-market/direct lending)
The report found that mid-market/direct lending funds investing in Europe had the highest average AuM with EUR388m, with bank loan funds averaging EUR269m and bond funds (e.g. Italian mini bonds) averaging EUR134m. By comparison, the largest funds investing in the US were bank loan funds (EUR414m), which makes sense given that 55 per cent of all funds investing in the US hold this underlying debt. The whole business of securitisation and management of bank loans by CLO managers and other specialists is far more advanced across the Atlantic.
One factor that could well encourage further product evolution within Europe is the ELTIF framework currently under discussion between the European Parliament and the European Commission; something that Bocci thinks could be highly advantageous as it could widen this asset class out to retail investors. In essence, European Long Term Investment Funds will be long-term illiquid fund vehicles designed to invest in SME corporate debt, infrastructure and so on. These funds will allow both institutional and retail assets to be deployed.
“This is for us another reason for feeling positive about the future of this asset class. Up until now this asset class has been available exclusively to institutional investors, at least in Europe,” adds Bocci.
Product evolution within the private debt space
One important facet of Prometeia’s report is the way it effectively illustrates and summarises the key features within the various sub-asset classes. Each has its own particular liquidity profile, fee structure, return target and fund size – see the graph in Figure 1. Before highlighting these differences, the key takeaway here is that a positive correlation exists whereby the higher a fund’s target returns, the higher the associated management fee is – see the graph in Figure 2.
Consequently, mezzanine funds are the most expensive with average management fees of 1.7 per cent and target returns of 12 to 17 per cent while bank loan funds are the cheapest, with an average management fee of 0.6 per cent but a more conservative target return of 4 to 6 per cent.
“One outcome of our analysis is that some of these sub-asset classes are more stable, some are more volatile depending on the underlying asset,” says Bocci.
“Bank loan funds are quite well diversified. They have a little bit of a shorter maturity to market and are very popular in the US. On the opposite side are mezzanine funds. These are run mainly be private equity managers. They are less diversified and have virtually no liquidity.”
Mezzanine finance is typically used to support the expansion plans of companies. It is a form of debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back on time. Typically, mezzanine funds are closed-ended structures and cater predominantly to institutional investors.
“In between are mid-market and direct lending funds and bond funds where the fund invests directly in bonds issued by the corporate. This particular sub-asset class is really starting to take shape in Italy at the moment,” confirms Bocci. Both direct lending and bond funds share similarities in terms of liquidity and portfolio diversification.
One point to note with respect to mid-market and direct lending funds is that the range of potential returns is much greater than other sub-asset classes. This is because of the heterogeneity of the underlying assets; all types of corporates, operating in all major industry sectors, are a potential target for managers wishing to originate loans. The loan agreement and length of maturity varies from manager to manager.
Prometeia’s report finds that within France approximately 25 per cent of funds that launched during the sample period were direct lending vehicles. This is much higher than the UK (6 per cent) and Italy (0 per cent) and even higher than the US (16 per cent).
These numbers will surely rise going forward and serve to emphasise just how big an opportunity Europe’s private debt market represents.
In an article published in the Financial Times on 11 May 2014, Chris Bone, an investment manager at Partners Group, a Swiss specialist in private market assets that manages EUR3.5bn in private debt, said that in Europe, five years ago, it would have been unusual to have “insurance companies, pension funds or debt funds in [a company’s] lender base. It is a fairly well trodden path now.
In Bone’s view, debt funds will continue to play a significant role in Europe, particularly in the UK, Germany and France.
One common thread that runs through all of the sub-asset classes is that when it comes to putting money to work, real estate companies and financial companies are not considered. Perhaps more importantly, the fact that these products vary so much means that asset managers have the ability to design products that can meet the exact return objectives of investor. This is a key point. As more products come to market, the more options institutions will have as they scramble to meet their long-term liability objectives.
In effect, there is a product for every type of return need within the loan and private debt space.
“The appeal of bank loan funds can vary from investor to investor, also according to “reference” government bonds returns of each single country: 4-5 per cent returns might be appealing to German investors, but for Italian institutions it could be less interesting due to higher returns offered by BTPs vs Bunds (10Y spread: +1.5 per cent as of mid June 2014), supporting therefore the search for debts with higher yields. Investing in credit funds specialised in different debt type allows investors to design their own risk/return as well as liquidity profile on the asset class,” says Guidetti, who adds:
“The other point is that bank loan funds tends to be an arena where generalist players compete. The mezzanine space is more for private equity specialists. Where these two types of asset managers meet is in the mid-market and/or direct lending space. There are therefore different approaches to the investment process of these funds, different target returns, depending on the type and size of corporates to whom the loans are being originated for.
“Generalists tend to offer more diversified portfolios and tend to offer lower returns than private equity managers who construct more concentrated portfolios to target higher returns. This is something that investors should be aware of.”
Italian mini-bond market
Mindful of the need to support small and mid-sized companies, Italy has introduced market reforms to allow these companies to issue bonds and raise capital without needing to rely on bank funding. What is ironic is that some of the investors in these mini bond funds are the very banks that reduced their lending according to an article by Private Equity International.
According to Bocci, over the last 18 months some 20-plus funds have been launched within this sub-asset class as managers look to gain a first-mover advantage.
“We estimate that the funding gap for Italian corporates will be EUR50bn per year for the next three years. It’s obvious that to maintain a sufficient level of investment Italian corporates need other sources of funding. That’s why there’s such growing interest among asset managers. By issuing non-listed bonds it is helping SMEs remain active in global markets, grow in new countries, buy machinery, conduct R&D etc.”
The Prometeia report notes that as of mid-2013, just six months after Italy introduced the reforms, there were already nine of these mini-bond funds targeting an estimated EUR1.4bn. By the end of 2013 that number had leapfrogged to 17 funds targeting an estimated EUR3bn, and has increased, today, to EUR4bn. This is good news for corporates and if, as Bocci points out, the estimated annual funding gap is EUR50bn, there is plenty of room for this particular fund product to grow.
This won’t, however, be confined to Italy. Hopefully, as other national regulators look for ways to support SMEs the private debt market will proliferate across Europe, or at the very least in countries where bank lending has traditionally been at the higher end of the scale.
At a broad level, what then does this product evolution with loans and private debt funds signify? Just how important an opportunity is this for the asset management industry going forward?
“I think for the European asset management industry this is a clear structural opportunity over the medium term provided the fundamentals remain structural,” says Bocci. “The behaviour of banks is predictable to some extent, balance sheets are shrinking and NPLs are at record high; there is, quite simply, a structural need for financing SMEs and whilst that exists it will support this alternative funding market. That’s why we think the asset management industry has responded quite significantly with the issuance of a wide number of new funds.
“We do not think the banking issue will be solved any time soon but at the same time SME’s cannot afford to stop innovation, potential M&A activity etc, with respect to their competitors on a global basis.”
In total, 29 per cent and 17 per cent of all funds (both open and closed-ended) analysed in the report are domiciled in Luxembourg and Ireland. Guidetti confirms that they continue to see more and more managers in the process of registering and launching new funds in these two domiciles (and to a lesser extent in offshore domiciles including Cayman, Guernsey and Jersey) and that such a trend will continue in 2014 and beyond. Moreover, recent introduction of the AIFM Directive will facilitate cross-country distribution across Europe in a more competitive environment.
Most of the largest asset managers are launching dedicated funds for their global investor base. Keep in mind that in the European market there’s been a good flow of new assets into the market as a consequence of these fund launches. There is a lot of interest among investors for these specialised debt funds.
“There’s clearly a widening of the product offering and that will encourage investors to allocate fresh assets into this market going forward,” says Guidetti.
Factor in the changes being made to the European regulatory framework in respect to ELTIF, to support both institutional and retail savings allocating into long-term asset classes, and the overwhelming conclusion one arrives at is that Europe’s debt market is set to evolve at pace over the coming years.
And that’s good news for all parties concerned: asset managers, investors, and of course, the SMEs themselves.
To order the Prometeia report, please click here
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