BNY Mellon has put out a new white paper about the alternative credit market, that is, about debt funds and the space where they dwell.
The paper looks at six points: macro background; investor demand; supply-side response; regulatory context; managerial difficulties; and the role of service providers.
This precis will take the same points in that order.
The Macro Background
Since the global financial crisis of a decade ago, banks have had to work on deleveraging their balance sheets, while making do with historically low interest rates. They’ve done this by refocusing on their core markets. As the white paper puts it, banks now restrict their lending books “only to a very specific range of well-understood and therefore risk-appropriate borrowers.”
This has sent those who want to borrow and who find themselves outside of that range … elsewhere. Hedge funds and private equity firms are among those who have served as alternative lenders.
Meanwhile, as banks are exiting the field for their macro reasons, non-bank investors are giving it a close look for theirs. Investors are attracted by the fact that loans historically offer a lower default rate than do high yield bonds. Also, in the event of a corporate default, loans have priority over bonds. In good times, they offer protection against inflation via the floating interest rate.
There are now roughly 250 private debt funds that are looking for an aggregate of $141 billion in capital commitments from such investors. They can reasonably expect to receive capital commitments because they can offer investors absolute non-correlated returns, comparing favorably to U.S. Treasuries. Indeed, Preqin says that the direct lending funds that were launched in the period 2008-2011 have attained internal rates of return of between 10% and 14%.
All this makes it worthwhile for investors, including institutions of all sizes, to accept the liquidity constraint that is an element of the market.
The world of non-bank lending has attracted a lot of regulatory attention. Some of it comes with the presumption that there is something innately shadowy about the whole market: hence the term “shadow banking.”
The European Securities and Markets Authority has been working to create a pan-Europe regulatory scheme for loan origination. This might include leverage limits, although as BNY Mellon says that idea has “not been received well by the industry.” Other less fiercely controverted measures deal with organizational and reporting requirements.
Meanwhile, in the U.S., one of the big regulatory issues facing the industry at present involves the classification of collateralized loan obligations under the Dodd-Frank Ac t. The present understanding is that issuers must retain 5% of the value of their CLO issuance.
In general, as the white paper say, “regulatory burdens are common to all asset managers, but will be very keenly felt in the debt space as the bespoke, non-standard nature of the assets can lead to high headcounts for those conducting all middle and back-office functions in-house.”
Technology offers “increasingly flexible solutions” to the difficulties facing managers, in particular managers who want to scale up their alternative-loan operations without losing their niche/expertise street cred.
Loans aren’t fungible, though. They may be negotiated in specific terms between a lender and a borrower, with “many individual nuances,” the white paper notes. Consider repayment schedules just for example. One may be semi-annual, the next monthly, yet another weekly. Consider also that multiple agent banks and registrars may be involved in any transfer of ownership. For such reasons, “settlement processes are very long compared with government or corporate debt, typically up to T + 16 in the U.S. and T + 20 in Europe.”
Work is underway, though, both in the U.S. and in Europe, to suppress these settlement times, a task that involves both the fund firms themselves and the infrastructure operators.
That observation brings the paper naturally enough to the role of service providers in the loan fund space going forward. Debt funds, the white paper says, require “appropriately tailored services and solutions across depository, transfer agency, fund administration, loan administration, reporting and accounting.”
They just happen to have a particular service provider in mind. “BNY Mellon has continually invested in providing out clients with an effective solution” for a wide range of instruments and jurisdictions.