The private debt revolution is here
By Gautier Despret, Regional Head of Private Debt, Europe, IQ-EQ
Nearly 175 years ago, Europe was engulfed by a springtime of revolution, as over 50 countries across the continent rose up against the old traditional monarchical structures, with the aim of creating new and fresh independent nation states. Fast forward to the present day, and a similar sense of revolution is being felt across the European fund and investment industry, with private debt leading the charge. And the world is primed for a revolution, as a perfect storm of market conditions, economies in need of capital, and increased regulation on bank lending has led institutional investors to diversify their assets, moving from the traditional equities into debt and more.
The new financer of the economy
From energy infrastructure facilitating renewable energy, to rebuilding war-stricken countries, there is an increased demand for capital. The energy transition alone needs $5.7tn in annual investment, according to International Renewable Energy Agency (IRENA). Banks, previously the backbone of the economy, are struggling to be the lenders they once were due to regulatory constraints. The Basel Committee’s recent Basel III reforms have increased the regulation, supervision, and risk management of banks as a direct response to the global financial crisis, adding hoops that banks must jump through in the lending process. Banks, as a result, are not as prepared to freely loan money as they might have in the past, and have become more reluctant than ever to take on high risk loans and finance the real economy under a more relaxed framework.
Additionally, inflation rates are soaring, with UK inflation hitting 9.4% in July, and central banks are raising interest rates, all meaning that the investment outlook is looking bleak for investors, as their stocks and shares, along with equities, are on the slide. The stage is set, and a revolution is needed, and private debt falls in the perfect position to lead.
The revolution hero
Private debt is already on the rise worldwide, having grown tenfold in the past decade, and has become part of a complementary financing model for banks, and investors, across the world. Money is beginning to flow into the asset class, with new investors keen to be involved, across both institutional and retail investors. Preqin data indicates that its growth will be rapid, accelerating to a CAGR of 17.4% between 2022 and 2026, and will become the second largest alternative asset class in the world. This expansive growth is only likely to continue in the current market, as it is a good inflation hedge, and offers the potential of strong returns for investors. According to Preqin, 91% of private debt investors intend to maintain or increase allocations to private debt over the long term.
Europe is already well positioned to be the global epicentre of the debt revolution, having consistently demonstrated double-digit growth, and Luxembourg is playing an influential role. Luxembourg is the second largest market for funds and has the structures in place to deal with the complexities that private debt funds are bound to face.
With great power comes great responsibility
But with this growth, comes greater regulatory scrutiny. Market share is increasing, as private debt assets skyrocket to a total AUM of $1.21trn, and private debt is slowly loosening banks’ tight grasp on the loan market. With this in mind, due diligence checks need to be increased.
But as with all regulation, it needs to be well considered to ensure the continued success of the private debt world. The European Commission has recently published its proposal for AIFMD 2.0, adding to the current comprehensive AIFMD set of rules for alternative funds, specifically targeted at harmonising regulatory framework for loan origination AIFs. Several rules are too restrictive and complex, possibly jeopardising the industry’s future. For example, the proposed rules will require any fund where the notional value of its originated loans exceeds 60% of its NAV, to be closed-ended. The private debt committee is currently locked in debate to prevent the detrimental effects that this could have.
Increased regulation will be storming in, and those involved in the industry will need unique technology, industry expertise and a thorough understanding of AIFMD requirements, to ensure that they don’t fall foul of the regulators.
Technology rules all
However, private debt firms can employ technology to help navigate the increasingly complex regulatory environment. Private debt funds are one of the most complicated funds to structure, with calculations needed across interest, monitoring of cash flows, covenants and collateral, alongside dealing with security agents (an agent to hold collateral and enforce rights in case of borrower’s default),facility agents (the representative between borrower and lenders), and above all, ensuring that the correct investors are paid the correct returns, at the right time.
The waterfall structures of private debt funds throw up another problem. On one hand, private debt funds are cash intensive, with cash coming in and going out at regular, but nonuniformed intervals. On the other hand, the double waterfall structure, with GPs and LPs grouped on one side, and lenders and banks on the other, means that all debt waterfalls work in unique ways. For fund managers to have an easier time staying on top of these complex calculations, private debt funds require an additional level of technological and debt expertise.
The opportunity is there for fund managers to take advantage of the private debt movement, but to do so they must make sure that their technology is up to scratch and modern practices have been put in place. Increasing the use of technology will help revolutionise the industry and further promote its credentials as the asset class of the future.
The world demands a change
Market conditions, the threat of worse to come, and constraints on banks’ lending sheets have all led to a landscape in need of a revolution – with a timely option that is going to increase investors’ returns, as well as being the financer of the real economy. Private debt is on the rise across Europe and is well placed to fill this void. But they must take note of the unique nature of private debt as an asset class, as well as new AIFMD regulations, which are due to be passed through the European Parliament at the end of this year. The asset class is a particular complex one, and one where a strong expertise is very highly needed. Private debt has a huge opportunity to lead a revolution to supercharging investors’ returns, but only if it falls into the right hands.