What wasn’t (mostly) talked about at FFA Europe

Calls for more ratings of subscription credit lines and expressions of optimism about the synthetic risk transfer market were the order of the day at the Fund Finance Association’s annual European Symposium in London last week.

The industry organization also once again broke one of its own records, with nearly 1,140 registrants for the event. That compares to about 875 last year, as all three of its symposiums (the FFA also holds one in Asia each year) continue to gain broader interest.

There was a certain sense of gridlock at the conference, and although activity in various sectors has increased – perhaps most notably in private debt funds, both as lenders and borrowers – others face various headwinds. Much of the talk I witnessed at panels shifted often to activity in America, deepening the sense that many market participants are either capacity constrained (mainly sub line lending banks), sitting on the sidelines waiting for regulatory and economic clarity or trying to get deals done only to face unattractive economics before the finish line.

One lender I spoke with said his bank has been trying to execute on a sterling-denominated NAV loan of diversified LP interests, and was sent back to the drawing board by an interested investor who wanted to buy it in euros, only to find that to do so would destroy the economics of the deal.

And while the private debt market is highly active in both lending and borrowing, I wonder if the economics will remain sustainable once new UK regulations come fully into effect, and, somewhere down the line, interest rates decrease.

But what wasn’t talked about much, at least in the panels I attended, was the coming regulatory wave in the UK and Europe.

There are three regulatory initiatives that could significantly impact areas of fund finance coming down the pipeline, and some lack of clarity with how, exactly, they’ll be implemented or complied with will naturally dampen transactional activity.

Curiously little was spoken about these rules, with a few exceptions where relatively brief draconian assessments were made.

“AIFMD is an extremely anti-manager regulation,” one panelist said.

AIFMD II and private debt funds

When it comes to private debt, perhaps the most concerning is the Alternative Investment Fund Managers Directive II, known by the hideous acronym AIFMD II (having woefully appended yet another syllable to the end of the already unsayable AIFMD).

The EU adopted the rule in February, and it will impose new leverage, liquidity management and risk retention requirements while also broadening the original regulation’s scope.

AIFMD II expands on the first’s requirement that alternative fund managers who securitize their originations (primarily in the collateralized loan obligation market) retain 5 percent of their securitizations, either of the equity or in a horizontal slice from the equity up to the AAA-rated bonds.

Now, they also face holding 5 percent of every loan they originate. Since, as one lawyer on a panel said, private debt funds are increasingly not just lenders, but borrowers and securitizers, that could result in a punishing requirement for those for whom securitization is part of their business strategy.

I’m not very optimistic that the economics for private debt funds will survive both this and future interest rate decreases, whenever they come. At the very least, I’d expect it to shock this market into a temporary, if precipitous, slowdown.

One panelist shared this view, saying (I paraphrase, here), “If your base rate is 5 percent, you’re originating at around 3 percent and you back-lever that to get to about 12 percent, that makes sense. But [if rates come down] and your back leverage only gets you to 8 or 9 percent, does that make sense anymore? I don’t think so.”

Basel 3.1 and “The Letter”

Basel III rules put in place in the 2010s have frequently been called Basel IV, to regulators’ chagrin, due to what were perceived as overly draconian requirements. Confusingly, in the UK, the Prudential Regulatory Authority calls their implementation of the rules Basel 3.1.

That regime is being implemented in stages, with relevant rules around credit risk coming into effect this quarter. It is expected to render some fund finance activities less attractive to systemically important banks, who will need to ditch their internal models for risk-weighted asset capital requirements in exchange for a standardized one. That approach will pretty fundamentally change the calculus for many areas big banks are active in, and NAV lending is likely to be among the products they pull back on.

One panelist said holding NAV on balance sheet is “six to seven times more punitive in terms of expense than other warehousing products we have” under the new rules.

And then there is the letter the PRA published, from two of its executives to the chief risk officer, only a week before the European Symposium.

In it, the executives expressed concern over bank exposures to the private equity industry, and stated it expects banks to consolidate its risk exposures well beyond just sectoral ones, but down to specific counterparties, something bankers say they’re not set up to provide in the first place.

The PRA also stated it expects banks to stress test those exposures.

No one I spoke with appeared confident they know how to accurately interpret the entirety of what the PRA says it expects.

Adding it up

But if banks pull back on NAV while private debt funds contend with risk retention requirements and – at some point, at least – lower rates, that could spell some trouble for NAV lending in Europe, since non-bank lenders like private debt funds are already crucial to expanding that market – banks only entered the ‘concentrated NAV’ part of the market in any significant way since rates have gone up. But who knows? Other types of institutional lenders may be drawn into the market as it matures and gains broader interest. Or, hopefully, my prediction is just flat out wrong!

As always, feel free to contact me at graham.b@pei.group or call me at +1 212-796-8332, or on LinkedIn with your thoughts, story ideas or tips!