Investment opportunities in debt fund strategies
By James Williams – Prior to the global financial crisis the ability for European corporates to finance themselves via leveraged loans was dominated by a prevalence of collateralised loan obligations (CLOs): in 2007, at its peak, the CLO market bought up two thirds of the USD166billion of leveraged loans issued that year, according to ratings agency Standard & Poor’s.
Banks would originate leveraged loans through a syndication process, whereby they and a number of other investors – including other banks and CLO managers – would each commit capital, and thereby diversify the risk. The CLO manager would repeat this process, investing in multiple loans by raising money from global institutions on the capital markets to create the CLO vehicle. The loan pool would then be sliced and diced to create a series of different layers or tranches – for example from AAA to BB – to provide income streams of varying risk; the more risk an investor wanted, the lower down the capital structure they would go to receive higher interest.
It was this ability for CLO managers to raise money on the capital markets and provide the necessary liquidity for banks to continue originating loans – just as they do with mortgages – that oiled the wheels of capital markets.
But since 2008 things have changed. Europe’s CLO market has dried up considerably, although it is far from finished. Just this year, a few deals have emerged which suggest that there are some green shoots of recovery – the US CLO market meanwhile continues to recover strongly – but what is evident is the number of new players entering the loan space.
Whereas previously institutional investors – traditional asset managers, pension funds, insurance companies – would invest in loans via CLOs, increasingly they are looking to invest directly or via third party asset managers. This new set of actors is playing a key role in providing credit to corporates who increasingly find that their banks are simply not willing to lend anymore.
This is because of tighter banking regulation under Basel III requiring banks to reduce and strengthen their balance sheets. The simultaneous reduction in bank lending and CLO activity has changed the European landscape; one where debt funds now co-exist with CLOs, and where alternative managers and CLO managers are starting to converge.
As Simon Perry, Head of Business Development, EMEA, at Alcentra, one of the world’s leading asset managers, explains: “We are raising more new capital from pension funds and insurance companies into unlevered vehicles: either segregated managed accounts, open-ended funds, or in the case of the Alcentra European Floating Rate Income Fund, which launched last year, a closed-ended listed fund that issues shares on the London stock exchange.”
BNP Paribas Securities Services (“BNP Paribas”) has reacted quickly to this evolving market. It has long been a leading provider of loan portfolio administration services, and has long had a fund administration service for private equity managers. Now, given that alternative managers are investing in loans as a new asset class, the firm is ideally placed to leverage its expertise in both areas.
Debt Fund Administration Services
Hugh Stevens (pictured) is Head of Private Equity and Real Estate Services at BNP Paribas Securities Services. He notes that the debt funds market has evolved rapidly in recent years. Whereas the early focus was on distressed debt opportunities, there is now a range of debt fund strategies including leveraged loan funds, infrastructure debt funds and real estate debt funds. All of which require specific structuring.
Investment opportunities for fund managers in the secondary market are not always straightforward. Managers have to pursue global market opportunities to effectively invest the fund’s capital. Factor in that fund raising remains challenging and the result, says Stevens, is that managers need to consider cross-border fund structures – this could be an offshore master/feeder structure to allow multiple investor types, or a European QIF or SIF regulated fund structure.
For most managers setting up a new debt fund, this can be a daunting task.
“Managers are realising that they need service providers that understand the requirements of investors in different markets, the regulatory requirements in different fund domiciles and understand the accounting treatment for investments made across multiple markets. It’s a complex process,” says Stevens.
“We have a strong cross-border distribution capability in UCITS funds and what we’re starting to see is emerging interest in AIFMD-compliant funds,” notes Stevens. UCITS is the gold standard for European mutual funds and has become highly popular with Asian investors. Cross-border distribution of UCITS is now commonplace. “If AIFMD-compliant funds gain the same brand recognition with investors in Asia then we’ll have a situation where those fund sponsors in Asia will require a strong European partner,” adds Stevens.
Regulation: a help and a hindrance
Without doubt, regulatory change is one of the key drivers behind Europe’s growing debt fund market. For banks, under Basel III the need to increase their tier one capital ratios is forcing them to deleverage and divest their riskier assets. By pulling back on their lending activities, a significant funding gap has opened up.
“We’ve had the financial crisis, we’ve had the reaction from the regulators, and now we need to digest those rules. Regulation has resulted in banks having to raise their capital ratios. They’re not lending in the same way anymore and that creates a tsunami of refinancing risk; the European market will evolve, but it’ll be a gradual process,” comments Oern Greif, Head of Debt Market Services at BNP Paribas Securities Services.
Stevens expands on the point: “If you look at the European real estate market, lending is around EUR2.5trillion. In the past this was predominantly provided by banks and partly through the securitisation industry via CLOs. If banks are pulling back from providing that lending, and the CLO market is subdued, you can understand where that funding gap is coming from.”
Debt funds are now helping plug part of that gap and are being helped by some government initiatives aimed at creating more liquidity for real estate distressed debt. For example, Ireland’s National Asset Management Agency (NAMA) was established in 2009 to buy up toxic loan assets from financial institutions.
This is prompting private fund sponsors to get more involved but as Stevens stresses, the flipside to this is that, as funds become more like banks, banking regulators are becoming more interested. A newly launched debt fund, could find itself having to operate under both fund and banking regulations.
“As a firm, we bring together our knowledge, our history and our experience of operating both in a regulated bank environment and a regulated funds environment. The fact that we have experience on both sides is a clear value-add for our clients.”
For new fund sponsors, it is important to know that against this regulatory backdrop they have a counterparty that will adapt and administrate the fund throughout its lifecycle despite continuously changing regulations.
“For our asset manager clients based outside Europe, we understand the difficulty in coordinating contact with multiple European regulators. For these clients, we are the partner who can keep them ahead of the changing regulatory environment; a partner who really understands the cultural requirements of the regulator in each market, particularly Europe,” notes Stevens.
Given the complexity of setting up multiple fund structures, there are two key elements to BNP Paribas’s loan fund administration solution that appeal to its clients:
Cross-location co-ordination: If a sponsor chooses different providers in each country then the sponsor has to provide co-ordination of all the cash flows, all the information flows, between the different locations. As investment opportunities become more geographically diverse it’s harder to provide that co-ordination and keep investors satisfied.
“We provide a single point of operational contact for our clients. For example, if the sponsor is located in London but the fund requires a regulatory filing in Luxembourg, our team in London will co-ordinate with our team in Luxembourg to ensure the regulatory filing takes place.
“Some clients have existing funds with specialist providers in different locations. They might have a boutique administrator in Jersey, one in Ireland, etc. They end up sitting between all these different providers and it’s not a comfortable place to be. Having offices in 33 global locations allows BNP Paribas to cover all the key locations within a fund structure.”
Cross-function co-ordination: In addition to fund administration, BNP Paribas also provides loan administration and investor servicing. All three components of the service are integrated. That’s not necessarily a common offering in the market. Often a firm will support fund administration and require the client to undertake some loan servicing themselves or find an additional specialist provider.
“Our clients do not suffer from this problem. We offer a complete solution for investor servicing, fund servicing and asset servicing,” says Stevens.
As well as this vertical support structure, the BNP Paribas solution runs horizontally, supporting the fund at each stage of its evolution. Stevens and his team work with clients during the structuring of the fund, help with investors’ operational due diligence, fund raising, closing the fund, servicing the fund through the investment phase, and then assisting with liquidating the fund when it reaches the end of its life.
This “matrix” solution developed by BNP Paribas has put it in a leading position to support a range of clients including securitisation issuers, private equity managers, asset management firms, insurance companies and banks in the burgeoning debt fund market.
Fund administration components
Corporate administration: This involves looking after the companies involved in the structure. BNP Paribas sets up the company, introduces independent directors, runs the board meetings, administers board resolutions and provides accounting and regulator filings.
Fund accounting: All fund NAVs are calculated, typically on a monthly or quarterly basis, though some funds are priced daily. “We meet with the auditors, set up the audit schedule, keep the books and records of the fund and then at year-end produce the financial statements. When the fund closes we run the payments waterfall, calculate the payments due to investors, receive the investor subscriptions and track the accounts – all cash flows in and out of the fund – through the fund’s lifecycle,” notes Stevens.
Fund performance: A fund administrator uses specialist systems and fund performance analysts to provide clients with a range of performance and risk analytics: for example, performance attribution analysis to track the sources of fund over or under performance. For closed ended funds, as the manager has some control over the timing of cashflows, the performance is expressed as an internal rate of return calculated to industry guidelines against all historic cash transactions since inception of the fund.
Compliance: A depositary will be required for any fund distributed in Europe or by a Europe-based manager starting from July 2013 onwards. Many European funds are already required to appoint a depositary, however, new regulations – the Alternative Investment Fund Managers Directive (AIFMD) – extend the requirements significantly. For example, depositaries will now be required to keep records to verify ownership of fund assets for any controlled entity within the fund structure. For a debt fund, depositaries must hold financial assets in custody and also supervise and keep records of any loan assets that cannot be held ‘in bank’. “It’s a due diligence process, making sure the fund has legal entitlement to those assets. Our systems must also monitor cash transactions to ensure the rules of the fund are being adhered to,” says Stevens.
Clearly the regulatory and structural complexities of setting up a loan fund are substantial, but equally as complex is the administration of the underlying assets making up a portfolio – that is, the loans themselves. They come in many different guises, and unlike bonds and equities, have myriad characteristics that require sophisticated administration.
Loan Administration Services
Oern Greif focuses on the asset side of the debt fund equation, and has over 20 years’ fixed income experience, the last decade of which has been spent at BNP Paribas Corporate and Investment Bank (CIB). Greif notes that securities services are becoming “immensely relevant” both to issuers and end investors as the debt fund market evolves.
The firm’s approach, he says, has been to profile the opportunity in loan funds but also to stress that “we are experts in loan administration, how the underlying collateral looks. Although loan funds are relatively new, we anticipate that they will grow in number. The dovetail between loan servicing and loan fund servicing is quite elegant.”
For new entrants, the prospect of overhauling their internal operations to accommodate loan administration is both costly and potentially burdensome. The inherent complexity of loans requires a sophisticated operational framework. Each loan requires interest rates to be calculated, principal to be redeemed and a plethora of reports to be produced.
Over the years, BNP Paribas has developed its expertise in the administration of leveraged loans. Today, the firm services billions of loan assets in approximately 350 active loan facilities on a daily basis – and as more new managers enter the loan fund space, that figure continues to rise.
Three client categories
BNP Paribas splits its client-base into three categories. Firstly, there are the banks and corporates; the traditional lenders and borrowers of loans.
As banks reign in their lending activity, a second client group has emerged: namely the asset owners, the big pension funds and insurance companies wishing to put their money to work. However, unlike banks these institutions are not natural lenders and as Greif explains: “They don’t typically have credit procedures to underwrite loans as banks would, they don’t necessarily have the back-office instruments to calculate the principal or monitor whether loan covenants have been breached: they either have to build that infrastructure internally or outsource it.
“The easiest fix is to invest in a fund structure rather than being a direct lender.”
This has created a third client group which BNP Paribas refers to as “credit managers”: alternative asset managers including private equity/real estate and hedge fund managers.
“They are what we call post-crisis CLO managers. We interact with all three: banks and corporates, asset owners, and alternative managers. The funds themselves come in many different varieties depending on tax and funding, jurisdictional issues, etc. Although they can be individually tailored they all essentially do the same thing: provide a fund vehicle to investors that wraps together loans, which are the collateral we service on a daily basis.”
Loan servicing – a robust solution
Prior to the financial crisis, BNP Paribas was already an active administrator in the CLO space. The motivation for doing so was due to a clearly perceived gap in service levels both in terms of how investors were supported, and the CLO managers themselves. The firm’s CLO team was established to meet that gap explains Stuart Draper, Senior Sales Manager, Client Development, Debt Market Services at BNP Paribas Securities Services.
“It goes back to basics (with respect to the loan service model). Firstly you’ve got to be responsive. In the CLO days, trades had to be checked before they were executed, and that check and response capability was in the hands of the collateral administrator. We became very successful in doing that, supporting a wide variety of debt structures, and built up a good book. Since 2009 the European CLO market has slowed, so we’ve had to adapt accordingly as debt funds have emerged in parallel.”
The second basic element is flexibility, whether it is for loan reporting, or the way in which relationships with managers are built. After all, every manager has different needs when it comes to their desired methodology of loan assessment.
BNP Paribas is in a prime position to support this burgeoning market. Within the securities services business, its experience in servicing loans means that the infrastructure is firmly in place. As Draper says: “We have a robust solution in place that needs to be driven and that’s why we are utilising it to leverage the debt fund opportunities that we’ve been seeing.” Equally, BNP Paribas Investment Partners, BNP Paribas’ asset management arm, has had teams of managers very active in the space from early on.
According to Draper, sponsors of debt funds typically come in two flavours:
• The ex-CLO manager: someone who is already familiar with loan structures and who already has their own legacy CLO infrastructure still in place. “That’s when we can assist managers to establish a fund in a consultancy capacity.”
• The alternative asset manager: someone who may have a track record in funds but not in loans as an investible asset class.
“The expanse of structures that loans can hold is wide and can sometimes come as a surprise to these managers who think ‘Wow, I actually need a lot of infrastructure in place here’. They may not know how long they’re going to be in this space because of the nature of the alternatives sector dipping in and out when managers see value. In such circumstances we not only do traditional collateral administration services for the fund, and monitor the portfolio, but also provide services to the investment adviser who may lack the internal administration tools needed to manage these loans,” notes Draper.
Reporting is the cornerstone
BNP Paribas has invested heavily in two key areas: pure administration, and granular reporting. Loans are sophisticated instruments but their method of settlement is not – typically a trade +10 settlement cycle – and is still highly paper-based. This can be challenging for managers as there’s often a myriad of defined deadlines. What BNP Paribas has done is build a loan administration team of individuals from the buy-side and the sell-side; in particular those with agency experience. This has helped create a well-rounded team capable of navigating any issues that arise in the loan market.
“There’s a huge variety of instruments: term loans, delayed draw loans, revolvers, mezzanine, first and second lien loans: all of which have slightly different characteristics and different ways of being administered. You need a robust system to do that. Also, PIK (Payment in Kind) conventions vary from jurisdiction to jurisdiction, so sometimes managers need our assistance understanding the concepts of how the underlying documentation and resultant cash flows will work,” says Draper.
Not surprisingly, loan reporting is a massive challenge for managers and represents a cornerstone of the firm’s loan service business. The analytical system used to monitor a portfolio and create reports has been constructed so as to provide bespoke deep-level reporting for managers, and consolidated summarised reporting for investors.
Explains Draper: “The quality and consistency of reporting needs to be high because loans have more characteristics per se than classic fixed income or equity instruments. Our bespoke reports, accessible on-line, give managers top line details such as NAV, etc, but we’re also supplementing this through granular reporting at the asset level.
“Our reporting architecture allows our team to update reports in accordance with requests from both the managers and their investors, incorporating more (or less) data. Ultimately, we want to ensure that the reports are visually appealing and high quality. Our ability to slice and dice data enhances transparency, which our clients demand.”
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