This is one of those rare occasions when everyone seems to be on the same page. Europe’s authorities want to diversify credit provision, especially for SMEs and infrastructure projects, away from systemically-risky banks and towards real-money investors.

The European Commission’s newly-released roadmap on long-term financing needs, following its 2013 Green Paper, includes moves to revive securitisation, improve information about infrastructure investment loans and push forward a more credit-friendly Solvency II. The European Central Bank (ECB) and the Bank of England both see re-energised asset-backed securities (ABS) as a more efficient way to get money into the economy than QE. EIOPA has responded by differentiating between higher and lower-quality ABS in Solvency II capital charges.

“We only have to go back a few years to find EIOPA effectively telling European insurers that this was not an investable asset class at all,” says Calvin Davies, head of securitised investments at ING Investment Management.

For direct lending, capital charges are already pretty favourable. Here the issue is one of standardisation; there are still only isolated efforts to undo the tangle of different issuance conventions and insolvency codes.

“This is the perfect investing opportunity,” suggests Anthony Fobel, head of private lending at BlueBay Asset Management. “You have a totally bank-concentrated market but the banks are broken and disincentivised and there are no other realistic financing options for mid-market companies; and you have institutional investors unable to get the income they need. The real question is why there haven’t been more funds raised to match these two things together.”

Why, indeed? Some impediments seem fixable. Pension funds that tended to divide their portfolios between liquid credit and illiquid private equity – and therefore had nowhere to put illiquid credit – are now carving out dedicated buckets for the opportunity. A trickier but still soluble issue is that asset managers launching private debt funds do so with little track record.

“A large part of the investor base in our first leveraged loan vehicle was making its first move into the asset class,” says Christophe Bavière, CEO of Idinvest Partners, a private equity manager that started offering lower-mid-market mezzanine in 2008 and higher-mid-market senior loans in 2013. “And the providers – people like us – are not raising Senior Loan Fund XV. It’s difficult to deploy assets with this lack of vehicles and experience.”

Mark Lyon, head of investments at the UK’s East Riding Pension Fund, which started diversifying its fixed-income and alternatives portfolios in 2010, recalls that he only had a choice of three or four European real estate debt specialists to choose from.

“Since then, many more have come to market, but of greatly varying quality,” he says. “Can they get access to deal flow? Can they put proper covenant packages in place? Are they able to assess the collateral and the underlying sponsor properly?”

In a recent IPE survey, other investors expressed similar frustration. The manager of the pension fund for one of the UK’s major lenders worried that new vehicles were coming from “hedge funds looking for the latest opportunity”, without the “depth and breadth of resources that banks have”.

If the asset-management business model simply cannot support those resources, very few managers may ever get to launch Senior Loan Fund XV. What are the prospects?

 

Expensive

Let’s take ABS. There are essentially two ways investors can get involved. They can take the top-rated tranches of super-prime UK and Dutch RMBS for Libor+150 basis points and use that to get some spread into their liability-matching portfolio. This was what Alex Thompson says that his firm, Mercer, was advising clients to do back in 2012 – but he concedes that it never really took off because the expected return was not enough to overcome investors’ wariness about the asset class.

The other approach, which Mercer has recommended since 2013, uses the full ABS universe to beat a high-yield benchmark, perhaps as part of a multi-asset credit strategy. Here, around BBB level, investors can get Libor+500.

Now that the leveraged players have left the top of the ABS capital structure, lower returns mean lower fees and, arguably, a strategy that only makes economic sense for big institutions.

“Investing only at the top of the capital structure in ABS is restricted to firms that, if not necessarily having the ABS-specific infrastructure in place already, have other things going on so that they can take advantage of economies of scale on the third-party administration side,” says Ed Panek, head of ABS investment at Henderson Global investors. “If you are just starting out and this is all you are looking to do, the fixed costs can be prohibitively expensive.”

Moreover, these securities generally don’t contain SME loans. To get that, investors need to go to the edges of the CLO market and private lending – largely the domain of hedge funds and private equity. Here, the risk is pushed higher to justify the fees to pay for the people and infrastructure required to get involved.

“Our clients often get shown interesting private credit ideas from hedge funds but that they don’t necessarily want the levels of risk, not to mention fees,” says Harriet Steel, head of business development at Hermes Fund Managers. “But in order to originate and manage the risk of these assets appropriately you do need the expertise often found within hedge funds.”

That expertise also needs databases and analytical tools to work with. While most agree that handling AAA UK RMBS does not require a huge outlay, things quickly get very complex in other markets.

“We haven’t been particularly attracted to UK and Dutch first-pays for our pension fund clients,” says Andrew Jackson, CIO at Cairn Capital – which structures ABS as well as managing assets, becoming the first non-bank arranger of a European CMBS, Debussy, in 2013. “We’ve been more interested in educating those investors to go a little bit further down the capital structure and be paid for a little less liquidity in a way that I’m not sure you are in the top tranches of RMBS.”

Jackson points out that Cairn’s decade-old structuring and advisory businesses furnish it with in-house models for virtually all of Europe’s legacy deals, a crucial extra analytical tool with which to overlay Intex, the industry-standard database and cash flow model.

“Intex does a reasonable job – and Intex itself isn’t cheap for an off-the-shelf product – but we have taken that and customised it thoroughly,” he says. “In 2011, for example, we received a lot of questions about redenomination risk on Greek RMBS: we ran our redenomination-risk stress scenarios, informed Intex, and three months later it introduced its own. There is a fair amount of systems spend which we’ve already done to build our advisory business.”

Move into US non-performing non-agency MBS and you enter a world of vast amounts of data and the wild uncertainties of pre-payment optionality. This is where CQS specialises and, since 2010, it has seen funds-of-funds money being replaced by pension funds.

“There is really no off-the-shelf solution for analysing US non-agency ABS,” says ABS product specialist Paul Heyrman. “You need to intelligently incorporate your own front end into third-party cash-flow engines, which embeds your assumptions about what’s going to happen in the loan-servicing business and regulatory environment. We have a database of 25m loans and counting, with hundreds of data fields per loan. This is not a PC-based system.”

Heyrman’s colleague, ABS analyst Justin Ryan, offers the example of one loan within an MBS that was transferred to a non-bank servicer “notorious for aggressive loan modifications”. CQS’s analytics enabled it to see the resulting huge impact on the level of expected debt reduction for this loan. Rather like Jackson’s point about Greek redenomination risk, Ryan adds that debt reductions were not so significant when the Intex databases were built back in 2005-06: “You need newer systems designed to analyse the loan market under today’s assumptions, rather than those of 2005,” he says.

The investment decisions Cairn Capital made to tool up for these markets felt less risky in 2004 than they would today, Jackson suggests, because securitisation felt like a growing industry. “Two years from now we may know more about the shape of ABS 2.0, but at the moment, certainly in Europe, it’s still in it infancy,” he says.

 

Dealflow

Move away from structured credit and into loans and systems become less burdensome. However, as anyone who has taken out a mortgage knows, this non-standardised, paper-based world is still a long way from the T+3 electronic settlement of high-yield bonds. Thompson at Mercer suggests that the reason loans specialists are not household names is that those household names have, so far, chosen not to make the necessary back-office investment.

If they do so – to take advantage of the appetite for multi-asset credit, for example – this would enable them to invest in syndicated loans originated by banks. However, the real demands come in direct lending, and they are less to do with systems and more to do with getting enough seasoned people to source the dealflow and handle the credit analysis.

“A lot of the opportunities around acquisition finance and leveraged finance, historically, came about because banks already had clients they wanted to hold on to,” says Ranbir Singh Lakhpuri, secured finance portfolio manager at Insight Investment. “That was a natural source of deals.”

Again, a boutique like Cairn Capital was set up to do this a decade ago. One of its first securitisations involved a pool of small loans at a UK bank and, after some years working on legacy CMBS, it now finds that much of its structuring business involves originating senior-loan deals, like the one it completed for Toys’R’Us in 2013.

“There is significant scope for us to grow a direct-lending franchise,” says Paul Campbell, Cairn’s CEO. “Through our advisory business, we have excellent relationships with all the UK’s accountancy and law firms where a lot of this mid-market lending is originated, and we’ve started receiving calls from CEOs and CFOs. The assumption was that because SMEs are starved of capital you could launch your loan fund and they would all come to you. But they won’t know about you – you have to go to them.”

This may be why the most natural place for this activity in the asset management world has been among private equity firms. At Idinvest, Bavière says that establishing a dealflow network is “not as difficult as people think”, as long as you maintain a kind of home advantage. For his firm, that means staying away from working capital and focusing on growth and acquisition finance for the sort of European buy-and-build deals for which it has provided equity for 20 years.

“You can’t deploy a buy-and-build strategy without debt,” Bavière reasons. “Building private debt expertise was a natural extension for us, which is why our contacts in this niche are valid and credible.”

But even when your move into loans grows naturally, it is not going to be easy.

“I can’t deny that it was a larger undertaking that we had initially expected,” says Bavière. “We recruited five new people in the front office, but the surprise was that we needed to hire just as many to cover the middle and back offices, and also for investor relations, because we were suddenly talking to the fixed-income guys in the institutions rather than the private equity guys.”

At BlueBay, where direct lending also tends to head into growth or acquisition finance, Fobel agrees. “It does require a lot of bodies on the ground and, this being Europe, people able to respond to local sensitivities,” he says. “Pulling together a coherent team with a good track record is difficult.”

Because direct lending involves originating and arranging loans, investors must accept that they will spend a lot of time chasing down deals they won’t necessarily win.

“You have to increase your resources to chase many more deals to fill up your bucket,” warns Martin Horne, manager of European loan funds at Babson Capital Europe. “We have nearly 90 people covering fixed income, loans and direct lending. You have to take a very long-term perspective and manage this well to justify P&L planning, [because you] are unlikely to have the AUM to cover the expense for some time.”

Of course, it is possible for large institutions to do this, but without the high fee model it is questionable whether the economics support time-intensive involvement in a relatively large number of smaller deals. It is notable that larger institutions like Allianz and Legal & General have tended to focus on infrastructure lending.

“We got into this business because the parent company, Allianz, sponsored a major initiative to make this a strategic objective, which gave us the security to make the investment,” says Karl Happe, CIO for insurance-related strategies at Allianz Global Investors Europe. “The big risk is accumulating a sustainable volume of assets, which does require a pretty big balance sheet behind you.”

Similarly, Legal & General Investment Management (LGIM) has favoured infrastructure over corporate private placements in illiquid lending for its parent. Head of pan-European credit research Georg Grodzki reckons you need one specialist for every deal signed off each year, plus one to monitor every 10-15 legacy deals as your portfolio builds. This is not exactly scaleable.

“It helps if you are owned by a large institution and you can bring size to the table – but, of course, that can be a drawback when it comes to smaller transactions,” he says. “This is why there is a natural draw towards larger transactions – you will spend as much time and resources on one large loan as you spend on one small loan. That’s not necessarily what the authorities focused on SME lending are looking for.”

Even then, Grodzki acknowledges that this investment is a significant risk.

“To make this worthwhile we have to have confidence in the pipeline being interesting for five years and beyond, and while there will always be a pretty decent volume of corporate bonds coming to market, with longer-duration assets re-financing doesn’t happen very often and so there is no built-in pipeline,” he says.

 

Loss leader

One way to minimise these risks is to partner with the banks that have the people, networks and systems to generate and process dealflow, but face regulation that makes it costly to use their balance sheets to do so. Institutional investors, on the other hand, have the balance sheet but need the infrastructure. A number of Europe’s banks, insurers and asset managers have spotted the opportunity, including AXA and Société Générale, which are working together to provide SME loans.

“The partnership involves the real-money manager buying into the origination capability at the bank,” says Société Générale’s global head of asset allocation Alain Bokobza, co-author of a major research publication on the institutional investment opportunity in loans in 2013. “This model appears to be growing popular here in Europe and it is one way to make fast progress.”

Allianz also got quite advanced in discussions on bank joint ventures, before going in-house.

“We never managed to get comfortable with the conflict-of-interest problem,” says Happe. “In theory, banks were willing to be Co-operative but when the rubber hit the road and we started talking about specific deals, the conflicts became very apparent.”

Banks may simply offer assets they don’t particularly like. But Happe says that, even when there was nothing fundamentally wrong with a deal, Allianz felt that there was no escaping conflicts over pricing. “We decided that if we were going to make a major commitment to this asset class, it was critical that we had an independent view on things,” he adds.

At BlueBay, which has recently started collaborating with Barclays for UK SME lending, Fobel insists that conflicts are limited because the institutional investor and the bank are looking for entirely different kinds of exposure. Banks have no interest in costly £100m loans at four times EBITDA to mid-market SMEs, but they do want the corporate banking business they bring. As such, they put forward a small amount of the loan and the investor takes the lion’s share.

“We are each taking the piece that we want,” says Fobel. “From our perspective, it enables us to take the higher-margin piece of the loan.”

Grodzki makes the same point around infrastructure loans, where LGIM has collaborated with intermediaries on a project-by-project basis, as well as lending direct. Often a bank will provide short-dated funding, while an insurance company will take the longer-dated part – an arrangement that suits each balance sheet perfectly.

Happe is not convinced. “There was always a debate about who should get paid what kind of spread for which tranche of a deal,” he says. “The banks, acting as both provider of balance sheet, and structure and arranger, always had a strong interest in making sure the tranches they retained had the best economics.”

However, perhaps the most pertinent question that arises from this discussion is really about the replicability of the banking business model in asset management. If conflicts of interest are limited because banks are not actually interested in the loans at all, but rather the ancillary business they can sell to the loan client – whether that is writing inflation derivatives against infrastructure debt or providing revolving credit or hedging for corporates – why are these loans attractive to institutional investors? A loss leader within a bank might simply be a loss for a pension fund.

When it comes to infrastructure lending, relatively low returns can be balanced against precious long-dated liability-matching benefits. With government paper too expensive and bank paper too risky, infrastructure debt is one of the few viable solutions for the long end of the curve.

“Even if the economic case is a poor one, the risk-management case can make the difference,” says Grodzki. “It may be annoying that other intermediaries walk away with very juicy ancillary profits, but we need duration and yield, and can’t find either very easily elsewhere, so that doesn’t affect our case for extending the illiquid long-term financing in a deal.”

However, Grodski finds it difficult to extend this logic into SME lending. While bank lending may not be unprofitable as such – just in terms of risk-weighted return on bank capital – the same balance sheet issues present themselves for pension funds and insurance companies.

“We have been approached with SME lending, but we haven’t proceeded because we are not sure it is suited to backing annuities, either in terms of credit quality or duration,” he says.

At the East Riding Pension Fund, Lyon hasn’t been persuaded by the numbers, either.

“We have seen a few funds where the return profile doesn’t really stack up with the risk profile, as far as we understand it,” he says. “This might not be riskier than many of the other things we are doing in alternative credit, but we feel that we have less visibility into our return profile and everything has to compete with that bucket of alternatives.”

These may be the teething pains of a financing model in its infancy – or the inevitable failures of an attempt to turn asset managers into banks. While US capital markets suggest that this isn’t a pipe dream, the US is fundamentally different from Europe and it is not yet clear that the same business models and economics can work on the scale that Europe’s institutions need or its authorities desire. We might all be on the same page; the danger is that we may be reading the wrong book.