European private debt: where do we go? - EY - United States_where_… · European private debt:...

European private debt: where do we go? October 2016

ContentsIntroduction 3

1 European private debt: market insight 4 a. The rise of direct lending 5 b. Funds’ size on the rise with shorter time to close 6 c. Outlook for the next 12 months 6

2 Origination from Luxembourg: where do we stand? 8 a. Regulatory environment 9 b. Legal structures used in Luxembourg in relation with loan origination

and competition from other jurisdictions 9

3 Specificities of the debt fund operating model 10 a. Insourced and outsourced services/operations 11 b. Accounting framework 11 c. Operating model 12

4 What makes Luxembourg successful? 14

Key items of the discussion 15

3European private debt: where do we go? |

The European private debt market has been drastically transformed over the last decade creating tremendous opportunities for the industry. The 2008 crisis was the game changer: the European credit institutions lending level notably shrank and they reduced accordingly their risk appetite. The trend has then been amplified by the new Capital Requirements Directive IV under Basel III leading European banks to reinforce their capital base and further reduce their loan books. This combination of factors left the European small and medium-sized enterprises (SMEs) with little access to capital while the economy was slowly recovering.

This created the perfect environment for alternative lending to step in and take over the traditional role of European financial institutions in the SME financing. The change has been further supported by the strong appetite from institutional investors faced with continuing low yields resulting from the successive quantitative easings from the European Central Bank.

Within the framework of our AIF Club program, in June 2016, EY invited 16 General Partners and service providers to attend a roundtable discussion about the European private debt market, origination from Luxembourg and specificities of the debt fund operating model.

This paper summarizes the outcome of this roundtable discussion and pays specific attention to the current private debt market in Luxembourg, discusses regulation around origination of debt instruments and draws the successful operating model to serve this asset class.

Introduction


4 | European private debt: where do we go?

European private debt: market insight

1


a. The rise of direct lending The European private debt market historically ranks behind the United States of America (US) market. This is explained by the general circumstance that companies (especially SMEs) in the US, approach capital markets for funding purposes rather than banks. The repartition between capital markets and credit institution financing represents 80%/20% respectively in the US as opposed to 20%/80% in Europe.

2015 confirmed this trend while the gap was significantly reducing on the back of the new capital requirement imposed to the European credit institutions. Europe actually even surpassed North-America for the first time in 2015 when it came to direct lending, as described on the chart on the right. As per Preqin1, fundraising in relation with European direct lending funds increased by 42% in 2015 compared to 2014. The above was largely confirmed by attendees of the roundtable with 65% of the audience confirming that direct lending is the current preferred strategy of the private debt industry.

1 Private Debt Spotlight, May 2016

0

5

10

15

20

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Year of Final Close

Agg

rega

te C

apita

l Rai

sed

($bn

)

North America-focused funds Europe-focused funds

Direct lending fundraising

Source: Preqin, 2016


c. Outlook for the next 12 monthsFrom a Luxembourg perspective, the most common strategy used on the market by far is direct lending followed by distressed debt (see graph below), which is in line with the figures at European level provided by Preqin. The report stated that as of June 2015, direct lending was the predominant strategy with 63% of respondents indicating the intention to target this strategy within the next 12 months while still confirming direct lending as the most preferred strategy, showing a steady strong demand.

What is the typical fund size you see in Luxembourg?

Within the European private debt landscape, what are the strategies you see developing the most over the last 12 months?

21%

57%

22%

31%

8%

15%

46%

€100mn - €250mn

Direct Lending

€250mn - €500mn

Mezzanine

€500mn - €1bn

Special situations/distressed debt

Real Estate debt

b. Funds’ size on the rise with shorter time to close

According to the attendees of the roundtable, the closing size of funds is recently on a positive upward trend with 78% of participants indicating current fund launches are above € 250m, out of which 21% are above € 500m and less than € 1bn. This is in line with the Preqin study that indicated that a typical private debt fund ranges between € 350m and € 1b.

As per Preqin, time spent on the road by Europe-focused private debt funds have significantly reduced. On average, closing took 11 months in 2013, 13 months in 2014 and 11 months in 2015 respectively, whereas 29 months were necessary in 2012 as largely confirmed by the attendees of the roundtable.

It was discussed with the attendees that distressed debt received increasing attention on the Luxembourg market during the last months, in line with the Preqin results which indicated an approximate 10% increase in demand for distressed debt between June and December 2015. Mezzanine only progressed slightly during the mentioned period.

Source: EY, 2016


Investors’ expected capital commitment to private debt funds in 2016 compared to 2015

Strategies targeted by private debt investors in the next 12 months, June 2015 versus December 2015

13%

41%

46%

0% 10% 20% 30% 40% 50% 60% 70% 80%

Proportion of respondents

Distressed debt 64%

53%

64%

63%

60%

58%

29%

33%

8%

9%

6%

5%

Direct lending

Mezzanine

Special situations

Fund of Funds

Venture debt

More capital in 2016 than 2015

December 2015

Same amount of capital in 2016 as 2015

June 2015

Less capital in 2016 than 2015

Overall, the respondents to the Preqin report and participants to the roundtable expressed a positive outlook for European private debt funds over the coming 12 months with 46% of investors expecting to invest more in 2016 compared to 2015. Overall, this leads to 87% of investors expressing their willingness to invest at least as much in the next 12 months than in 2015.

Source: EY, 2016



Origination from Luxembourg: Where do we stand?

2


a. Regulatory environmentAs a result of the significant inflow in the private debt industry, the European Commission has started to have a closer look into regulations relating to this type of fund. Even though this could be perceived as a threat, the attendees concluded that this evolution should be seen as an opportunity leading to a formalized market playing field.

During the roundtable, the attendees emphasized that there is no necessity to issue a dedicated regulation in Luxembourg on loan origination but that a questions and answers (Q&A) type of document would be highly appreciated especially on the topics of valuation and risk management. Another argument put forward was that mainly institutional and well-informed investors invest in private debt funds and hence no additional investor protecting regulation is required.

Luxembourg’s supervisory authority, the CSSF (Commission de Surveillance du Secteur Financier) provided more clarification on the topic by issuing the latest frequently asked questions (FAQ) on alternative investment fund managers (AIFMs), shortly after the roundtable on the 8 June 2016. The FAQ state that loan origination and loan participation/acquisition are per se not actively prohibited by the alternative investment fund manager directive (AIFMD) and the respective product laws. The CSSF mentions though that several aspects should be considered by an AIF/AIFM, among which the Law of 2013 and the respective product laws. Several key principles shall as well be adhered to by the AIFM, or the AIF itself, when engaging in loan origination or loan participation/acquisition:• All aspects and risks of this activity should be addressed• Proper organisational and governance structures and

appropriate technical and human resources• Necessary expertise/experience in origination activity, with a

focus on credit and liquidity risk management, concentration and risk limitation, clear policies regarding assets and investors, proper disclosure and transparency

Overall, the AIFM, or the AIF itself, should guarantee the implementation of a robust and appropriate approach to loan origination in general. The requirements will be evaluated by the CSSF in the context of the approval and during the on-going supervisory process (if applicable, on a case-by-case basis).

b. Legal structures used in Luxembourg in relation with loan origination and competition from other jurisdictions

Overall, the attendees stated that Luxembourg offers an adequate toolbox of vehicles and structures when it comes to origination. In fact, the attendees unanimously confirmed that they see Luxembourg as a competitive market place to set-up appropriate structures for the origination of loans.

Specialized investment funds (SIFs) and securitization vehicles are the most used structures for loan origination (see graph on the right, at the top). Attendees also argued that only around 25% of the Luxembourg structures are unregulated vehicles. European long-term investment funds (ELTIFs) however are not considered to be an appropriate solution except if a tax efficient approach might be bundled with it.

Which type of platform would you typically see for loan origination from Luxembourg?

When Luxembourg is not used to originate European loans, which jurisdiction would typically be used?

38% 8%

39%

15%

50%

7%

43%

S.à r.l./S.A./S.C.A.

Ireland

S.C.S./S.C.Sp

United Kingdom

SIF

France

Securitization vehicle

In case private debt funds are not set up in Luxembourg, the main competitors among the countries having adopted a dedicated origination law are Ireland and the United Kingdom. It should nevertheless be noted that the roundtable was held before the Brexit. The attendees shared the opinion that especially Ireland’s move towards an origination law had a positive impact on the market and was particularly well perceived by US initiators, who traditionally have a strong relationship with this jurisdiction.

Moreover, the attendees expressed the opinion that Malta should also be counted among competitors since the origination law in place has started to be considered by certain players.

Source: EY, 2016

Source: EY, 2016


Specificities of the debt fund operating model

3


a. Insourced and outsourced services/operations

As a general tendency, the attendees stated that accounting/fund administration, corporate secretariat, tax services, transfer agent and loan servicing are outsourced. Deeper insight was provided regarding several aspects:• The main reason for outsourcing accounting/fund administration

seems to be the regulated environment in place.• With regard to domiciliation, the figure was not as clear with

insourcing and outsourcing displaying an equal proportion of collected responses. Luxembourg debt fund providers usually prefer to self-domicile their vehicles even though smaller players are ready to take on the risk of outsourcing given that this solution is more economical. In this context, one participant indicated that the larger players should at least have a middle office in each market that they are active in.

• In relation to loan servicing, a few small niche players in addition to the big players dominate the market. Over the past years, a clear demand for those services emerged leading to the necessity to include it in the Luxembourgish set-up. Larger players offer loan servicing via shared services over the European Union (EU). For loan servicing performed in-house, Excel is the preferred solution.

AIFM

Outsourced services Outsourced/insourced Insourced

Corporate Secretariat

Accounting and fund

administrationDomiciliation Risk

Management

Tax Transfer Agency

Loan Servicing

b. Accounting frameworkWith regard to the accounting framework applied for private debt funds, the attendees highlighted that one decisive factor is how valuation is tackled. 46% of the attendees of the roundtable mainly use Luxembourg GAAP followed by 39% who use the IFRS amortized cost approach.

As a conclusion, the attendees believe that the service offering will remain with the larger players. A remaining concern among the attendees was investor reporting, for which a more extensive service offering would be highly appreciated.

What is the accounting framework most broadly used?

46%

15%

39%

IFRS

Luxembourg GAAP

Luxembourg GAAP (cost)

The attendees suggested that the industry should propose valuation methodologies that are appropriate under Luxembourg GAAP and that address the valuation of debt instruments held, using a “buy and hold” strategy. The idea of having a complement to the International Private Equity Venture Capital Valuation Guidelines that applies specifically to the private debt held in isolation of equity instruments has been largely subscribed by the audience.

Lastly, the attendees agreed that given the possibility of Luxembourgish limited partnerships (LPs) to build their own accounting framework, the current preferred solution is the use of IFRS (amortized cost approach) and carve out IFRS 7 (i.e., disclosure of fair value in the notes to the financial statements). It comes naturally that the benefit of using the cost approach is to avoid fluctuations in the funds’ income statement.

Source: EY, 2016


c. Operating modelOver the past years, investor requirements and preferences resulted in an increased influence on the operating model in use by the funds. The attendees identified the type of instruments issued by the platform, the use of master/feeder structure and the listing of instruments issued as one of the most important factors.

Given the current market progression and investor appetite for private debt funds, the market players are seeking further guidance and best-practice standards. Within these, pricing/valuation, deal flow and performance seem to be the most significant challenges, which was confirmed by the attendees of the roundtable. In addition, Luxembourg players indicated that fee pressure experiences a growing impact as well.

How do investor requirements and preferences shape your platforms?

Reporting and regulatory

Platform location tax, legal and reputation wise governmental program requirements

Type of instruments issued by the platform, use of master/feeder structure, listing of instruments issued

Use of parallel structures

0

10

20

30

40

50

Very important

Important Neutral Notimportant

41.67%

33.33%

16.67%

8.33%

0

10

20

30

40

50

60

Very important


38.46%

53.85%

7.69%

0%

0

10

20

30

40

50

Very important


42.86% 42.86%

7.14% 7.14%

0

10

20

30

40

50

Very important


28.57%

42.86%

28.57%

0%

Source: EY, 2016


Investors’ views on the key issues for the private debt market in 2016

0 5 10 15 20 25 30 35

Proportion of respondents

Pricing/valuations

Deal flow

Performance

Fulfilling Investor Demands

Regulation

Fundraising

Transparency

Fee pressure

Other

Availability/pricing of debt financing

Ongoing Volatility in Global Markets

31%

27%

25%

16%

11%

11%

10%

10%

9%

7%

26%



What makes Luxembourg successful?Luxembourg offers a one-stop-shop solution from the investors’ vehicle to the target investments. Compared to larger countries, Luxembourg is a stable and innovative player which attracts fund initiators distributing their funds to a varied European and international investor base. The European passporting offered by the AIFM makes it a preferred jurisdiction to establish both the Manager and AIFs.

Another virtue of Luxembourg is its strong service provider infrastructure including its position as a risk management hub in relation with debt instruments. Several large private debt managers have already successfully chosen to establish their operations in Luxembourg which creates a virtuous circle for the industry.

Lastly, the commitment of Luxembourg to further develop a prosperous fund market is incontestable and the foreseen law on the reserved alternative investment fund2 is regarded as a very attractive structure and another proof of Luxembourg’s ability to attract alternative investments funds (AIFs).

2 Issued on 14 July 2016

4


Key items of the discussion • ⇒On the back of the stable yield and superior risk return than private equity or listed instruments, private debt has become the

institutional class of assets.

• Among the strategies, direct lending is ⇒growing at the fastest pace and the industry sees it as a key driver for the years to come.

• The US remain the epicentre of the lending industry, but its growth engines will be in Europe over the rest of this decade.

• The uncertainty regarding origination of private debt funds has been ruled out by the CSSF with the issuance of a dedicated Q&A in June 2016: loan origination can be performed by AIFs

• The reserved alternative investment fund governed by the Law of 14 July 2016 is expected to be widely used to distribute AIFs across Europe and internationally.

• The development of dedicated valuation guidelines in relation with private debt held in isolation would bring clarity to the industry.


EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

© 2016 Ernst & Young S.A. All Rights Reserved.

ED None

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

ey.com/luxembourg

Contacts

Laurent CapolaghiPartner, Alternative InvestmentsEY Luxembourg+352 42 124 [email protected]

Michael HornsbyPartner, EMEIA Real Estate Funds LeaderEY Luxembourg+352 42 124 [email protected]

European private debt: where do we go? - EY - United States_where_… · European private debt:...

Documents

Transcript of European private debt: where do we go? - EY - United States_where_… · European private debt:...