Private loan funds

Capital V #9 | by Arnaud Bon

In the aftermath of the global financial crisis, the words “credit crunch” were on everyone’s lips within the Private Equity industry.

Bank restructurings and the increasing cost of capital deprived PE fund managers from a traditional source of leverage, reinforcing the importance of direct lending by investment fund managers as a dedicated asset class.

While the U.S. debt fund market reached maturity long ago, the European market focused essentially on secondary mezzanine debt acquisition rather than on loan origination at a time that it was still dominated by credit institutions.

Over the last few years, however, not only has the European market shown an increased attractiveness, but lawmakers and regulators have come to realise that the activity of private loan origination could be an alternative source of financing for the European economy.

A growing market meeting a macro-economic need

Private loan fund managers achieved an outstanding high level of fund raising (six-year high) with USD 85.2bn raised from 120 funds closing in 2015. Dry powder was hitting, mid-2016, a record-high USD 199bn – a significant proportion of USD 512bn PE dry powder.
The industry remains strongly U.S.-dominated both from a general partner and a limited partner perspective. In Q3 2016, three out of four of the largest loan funds were launched out of the U.S., by Bain Capital (USD 3.1bn), Audax Mezzanine (USD 1.2bn), H.I.G. (USD 1.1bn) and Penfun Capital (USD 556m). TIAA also remains by far the largest contributor to private debt with a current allocation of USD 25.9bn (3% of its current assets).
2016 is also marked by a geographic shift. While the loan origination investment activity remains strongly driven by the U.S. market, the European scene is slowly catching up and reaching maturity. Preqin 2016 Private Debt Quarterly Updates have consistently pointed out Europe as being the main investment target region for the coming months.

The path to an harmonised European framework

In parallel with these promising market trends, awareness among European policymakers is rising as to the importance of private loan origination as an alternative for financing the economy. In its “Action Plan on Building a Capital Markets Union” , the European Commission recognises loan funds as the way to “further diversify credit intermediation and increase financing opportunities”, hence easing credit access for SMEs. The Commission however points out the importance of ensuring loan funds are “regulated appropriately from an investor protection and financial stability perspective”. Anticipating a potential new piece of European legislation, the European Securities and Market Authority (ESMA) issued an opinion on 11 April 2016 with a view to set the main topics that would need to be addressed in this context.
In its opinion, ESMA generally raises questions rather than take strong positions. Such questions will, however, most probably shape the debate which will for sure emerge from the implementation of a dedicated loan fund regime, should there be one. First and foremost, both loan origination (originating new lines of credit) and loan participation (acquiring an existing line of credit on the secondary market) are addressed by this opinion. ESMA is considering the creation of a harmonised framework which would materialise either as a legislative proposal or by way of an ESMA instrument supplementing the AIFMD. It is unclear at this stage whether alternative investment funds (AIFs) qualifying as debt funds would be subject to a special authorisation regime or would fall within the common AIFMD regime.
A specific regime would most probably focus exclusively on loan origination, excluding loan participation or loan restructuring from its scope. ESMA’s opinion focuses on the potential risks inherent to the origination activity and the best way to monitor such risks both at systemic and portfolio levels, hence recommending the creation of specific regulatory obligations as well as specific processes and risk management frameworks.
ESMA takes the view that debt originating funds should be closed-ended by default unless certain conditions, similar to those applying to open-ended ELTIFs, are fulfilled. The opinion also expresses ESMA’s concern as to the eligibility of retail investors in loan origination funds. Minimum requirements applying in case such investors would be considered as eligible should be inspired by the ELTIF regime, making them practically unattractive to fund managers.
Finally, the opinion identifies categories of counterparties, such as consumers, which should be forbidden from contracting debt from a debt fund. Other categories such as credit institutions might prove restrictive in an environment where private equity investment, in equity or in debt, is sector agnostic.
With its opinion, ESMA is setting the tone for discussions to come in the coming months, which could be led in parallel with the planned assessment of the AIFMD in 2017. Harmonising at European level the regulatory and legal regime is certainly going in the right direction, but the multiplication of special EU regulatory regimes should be avoided where the mere amendment of an existing piece of legislation could achieve the same goal.

Luxembourg market readiness

In reaction to the ESMA opinion, in June 2016 the Luxembourg Supervisory Authority of the Financial Sector (CSSF) published an update of its AIFM Law FAQ. The CSSF thereby confirms that Luxembourg AIFs may engage in loan origination, loan acquisition or loan participation activities, subject to specific organisational and operational requirements. In particular, such AIFs shall comply with the specific product laws they are subject to (if any) and ensure they have an adequate governance, expertise and risk management approach with respect to loan assets.
The CSSF thereby clarified its position, bringing more legal certainty to an existing market practice.
Luxembourg has indeed been hosting loan (origination and participation) funds for many years, leveraging on a sufficiently flexible legal and regulatory framework while developing operational tools and expertise.
Among the most commonly used vehicles, the Luxembourg specialised investment fund (SIF) has shown a great deal of flexibility to accommodate loan fund structuring. Since its inception in 2007, new types of vehicles were added to the Luxembourg toolbox, some of them such as the EuVECA and the ELTIF, being driven by European legislative initiatives.
Market players have also adapted to this growing trend, developing expertise and know-how specific to the PE debt asset class in term of operations (e.g. cashflow reporting, trade processing), valuation or risk management.

With a number of loan fund managers already operating Luxembourg AIF and some of them transferring their middle office in the Grand Duchy, the financial centre has successfully positioned itself in a new industry, the macro-economic benefits of which are well advertised.

“It is unclear at this stage whether alternative investment funds (AIFs) qualifying as debt funds would be subject to a special authorisation regime or would fall within the common AIFMD regime.”