Private debt has long attracted institutional investors seeking yield, with 40% average growth in assets under management in Luxembourg alone in the 12 months to June 2021, according to fund industry association Alfi. However, with this stellar rise in AUM to €182bn comes increasingly complex demands for asset servicing–from reporting requirements to transaction volume to investor onboarding.
“Because it’s the debt market, it’s the largest spectrum [of services] you can imagine,” said Despret. “When you do debt you can originate, syndicate, do a club, do secondaries, put in place senior secured debt or even unitranche. Then you have leverage, multiple currencies, cashflow reporting and requirements.”
Despret argues that private debt’s requirements and its transaction volume make it a more complicated asset class to service than its alternative asset predecessor, private equity.
But service private debt Luxembourg must. As a financial services centre of excellence in Europe, Luxembourg cannot afford to let the private debt opportunity pass it by as other jurisdictions will be only too happy to become domicile of choice for this growing alternative asset class.
Fortunately, as far as third-party management companies (mancos) go, Luxembourg is “developing extremely well”, said Despret. “But it is facing challenges from the private debt world.”
Institutional investors take a pause
One of the first challenges for mancos is the upcoming recession in both the US and Europe, which, according to Despret, will stem the flow of institutional investor capital into private debt funds.
“Private debt has grown constantly but in the past two years we have seen a decrease in fundraising over the first half of each year, followed by a rebound in the second half.” Despret says the finger is being pointed at covid for the decrease in H1 2021, and the invasion of Ukraine for the same slump in H1 2022. “We could see possibly even the same in H1 2023 as we come out of a bad winter in Europe.”
The dips illustrate how institutional investors are likely to pause in a traditional, closed-ended, illiquid market like private debt. “So more and more we’re seeing the retailisation of funds,” said Despret. “So more sophisticated high net worth individuals knocking at the door. We’re seeing good products like the European Long-Term Investment Fund (a framework for retail investors to enter into alternative assets). We are seeing asset managers buying dedicated feeders (funds that channel sophisticated retail investor capital into alternative assets). But retail investors involve challenges.”
The principal challenge being, according to Despret, the mixing of liquid and illiquid strategies in a private debt fund, necessitating a move from closed-ended into open-ended funds.
“We’re talking open-ended funds with ten institutional investors plus one thousand or more retails,” said Despret.
“The reporting requirements are not the same between these two types of investors, and the right technology [is needed] to do reporting distributions.”
Services have developed to cater to this, most notably software solutions that streamline fund administration.
Europe-wide regulation of alternative investments aims to harmonise cross-border transactions. However, certain iterations in the Alternative Investment Fund Managers Directive (AIFMD) would restrict the activity of precisely the kind of private debt funds needed to welcome retail investors.
“The [potential restrictions] on AIFMD loan origination are not fixed yet,” said Despret. Previous AIFMD drafts had proposed that if more than 60% of a loan fund contained originated loans, then the fund must be closed-ended. Although it appears as though this stipulation might be relaxed in the regulation’s final iteration, the focus on loan origination will still require the support of mancos.
“You can’t put everything on the secondary market,” said Despret, referring to the importance of originating loans in private debt. “[Therefore] more controls will need to be performed when loans are originated, additional duties and additional checks.”
Environmental and social governance
The importance of ESG reporting hangs over all alternative assets, not the least private debt. And to do this properly requires specialists and an entirely new spectrum of specialist services.
“All asset managers have an ESG policy, but building an ESG scorecard that’s robust and coherent, that defines the KPI, collects the data, ensures it’s accurate–that is the challenge,” said Despret.
In many cases, private debt funds are accompanied by a private equity sponsor that holds equity in the deal, presenting a new set of challenges to the lender who has to make sure their ESG objectives are in harmony with those of the private equity sponsor. This can sometimes bring the pair into conflict.
“What do you do if it’s not good news? What’s the impact on the valuation of the underlying company–what do you do as the debt holder–ask the corporate to pay more interest?” said Despret.
For third-party mancos, ESG requirements change reporting. “Article 9 is very difficult to put in place in terms of reporting,” said Despret. “Whereas Article 8 says that you will take ESG considerations into account, Article 9 is more of a positive screening.”
According to Despret, funds doing Article 9 currently have their own internal rules on how it is defined. “There’s some subjectivity there, even with the guidelines.”
What is more, Article 9 is a challenge to the lending psychology. “I’m not sure lenders are ready for Article 9 because they are lenders and what is more important to them is the return. It is the financial industry, the first requirement is returns.” All of this presents challenges to mancos to create ESG reporting process suitable for the unique requirements of private debt.
Onboarding a new investor breed
Alternative asset classes in general are facing the challenge of onboarding a marked increase of investors. A large and granular base of small-ticket retail investors will gradually join the stalwart handful of big-ticket institutional investors, particularly in private debt.
“Equity markets (shares) are performing poorly so fund managers are often doing diversification strategies with debt to compensate,” said Despret. “The decorrelation of shares with debt–lots of investors are using private debt to mitigate return variation.”
As a result, a new model of investor relations is emerging, whereby the asset manager keeps the institutional investor relationship, but the relationship with the larger retail investor base is held by the investment adviser–often the placement agent or the bank through which the retail investors access the fund.
A number of very different processes will therefore be required both for onboarding and for relationship management. “This is why they outsource more and more, delegate to technology,” said Despret.
There has been an increase in the number of third-party mancos that provide software to streamline the onboarding process for a more fragmented investor base. The technology can speed up the necessary know-your-customer and anti-money-laundering processes that would otherwise stall fundraising if done manually. Then there is the burden of ongoing asset valuation needed in an open-ended fund. Performing this internally or delegating it to an external party requires time-chewing methodology and data modelling as well as administrative and accounting procedures in place.
However, distributed ledger technology has been used by financial services providers to relieve the operational burden on alternative investment managers. A digital shareholder registry and software will have the edge over traditional third-party outsourcing.
“Private debt is the only alternative asset class experiencing constant growth. You see lots of services developing in private debt. We see more and more competition,” said Despret.
This article originally appeared in the Delano 2022 alternative funds supplement
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