Overwhelming demand for capital from Europe’s small businesses has driven a 41% surge in Luxembourg’s private debt funds in the past year, delegates at the Association of the Luxembourg Fund Industry conference revealed on Tuesday. In the 12 months to June 2021, assets under management in private debt in Luxembourg hit €181.7bn, a 40.6% increase year on year.
Private debt funds, which structure and hold bespoke debt packages for a diverse borrower base, have attracted increasing inflows over a number of years, according to Hilary Fitzgibbon from asset manager Ares Management. “This [leap] is part of a longer-term trend. European markets are opening up at the same time as more companies are getting used to private debt as a way to finance their activities,” she explained.
Francesco Battazzi, of the European institution the European Investment Fund added that Luxembourg is the country of choice for pan-European debt funds. “Around one-third of the funds in which the EIF invests are based in Luxembourg. I believe going forward the larger funds will remain in Luxembourg while the smaller funds will launch in their country of origin then issue follow-on funds in Luxembourg in order to grow their investor base.”
The report into private debt, carried out by KPMG Luxembourg and the Association of the Luxembourg Fund Industry, showed the 41% increase concentrated in the direct lending activity of private debt funds as opposed to restructuring activities. Businesses weathering multiple lockdowns found a flexibility in private debt funds that bank lending could not provide. This ranges from committed acquisition facilities for those adopting a buy-and-build strategy, tailored debt offerings and flexible covenants.
Investors have equally become more comfortable with the private debt proposition over time, the delegates explained.
“Portfolio management is everything,” said Fitzgibbon. “Working closely with the companies and their private equity sponsors, proactively putting measures in place, pushing out covenants or creating more headroom--this way we keep companies on track and minimise defaults.”
A relatively young asset class, the 2020 covid-19 crisis is the first downturn faced by private debt. “Funds have shown a stable performance throughout the year,” said Battazzi.
Environmental and social governance opportunities
The increase in private debt AUM has benefited ESG goals, pointed out delegates, with the tight relationship between lender and borrower opening up incentives for ESG criteria compliance. “Margin ratchets are a tool to encourage the borrower to engage with ESG,” said Douglass Welch at Pemberton Asset Management. “The borrower is offered the opportunity to pay less if they perform to certain ESG criteria.”
One public example of this is Ares Management Corporation’s £1bn refinancing of UK environmental business RSK Group, which included an annual margin review based on the achievement of sustainability targets capable of saving RSK over £500,000 per year.
The Sustainable Finance Disclosure Regulation has also been eagerly adopted by the asset class, said Battazzi. SFDR article 8 and article 9, which distinguish between investments with sustainability characteristics and investments with a sustainability objective, respectively, feature in 50% of the debt funds in which the EIF has invested in the past year, according to Battazzi.
Amendments to AIFMD
Yet there are some clouds on the horizon for private debt in Luxembourg. Until now, the grand duchy has offered a liberal regime for loan funds, but proposed amendments to the Alternative Investment Fund Managers Directive will restrict some of the benefits that have allowed this market to thrive, suggested Martin Mager, partner at Linklaters.
“Upcoming proposals that prohibit open-ended funds under certain criteria are too restrictive, as is the proposal to retain 5% of the value of the fund if the loans are sold,” said Mager, referring to the European Commission’s proposition that AIFs which originate loans for more than 60% of their net asset value must be closed-ended and that AIFs must retain a 5% exposure to loans they have originated and subsequently sold on the secondary market.
However, some of the clarifications to harmonise the regulatory framework for loan origination funds could be positive for the asset class, Mager added. “On the positive, the clarification around loan origination allows us to originate cross border and to create a level playing field for the asset class in Europe.”