The Rise of Private Credit Funds and the New EU (AIFMD) Rules
Private Credit Funds seems to be on the rise, read e.g. this latest article by Bloomberg titled “ Why Private Credit is Booming and Banks are Fighting Back”. A reason for the rise is the difficult access to traditional bank loans or the unfavourable terms often offered by banks for small companies. Private credit funds have stepped into the gap left by banks after post-financial crisis regulations has tightened the lending to small businesses. This blog will delve into the intricacies of private credit funds, exploring their associated risks, and offering insights into the forthcoming amendments to the Alternative Investment Fund Managers Directive (AIFMD).
Overview
Booming Market
According to the European Commission, the EU market for Alternative Investment Funds (AIFs) has reached EUR 6.8 trillion in net asset value (NAV) at the end 2022, while the EU market for AIFs provides over EUR 250 billion to Union businesses in private credit.
In the US, as reported by the Fed and as shown by figure 1, private credit has grown exponentially since 2000, reaching nearly 1.7 trillion dollars. This is comparable to those of leveraged loans and high yield (HY) bonds. Furthermore, it has been observed that there is also a growing amount of committed but uninvested capital (also known as dry powder).
This rise has met with some unease by regulators and investors. According to this latest FT-article, investors are getting nervous under the high interest rate as investors are reducing the amount they allocate to private equity.
The risen popularity has not been unnoticed by the European Commission. Hence recently the Council, see this press release, has approved on a new set of rules to limit the risks of private credit funds.
source: Fed
What is Private Credit?
A company in need of financing for their business ventures, traditionally can go to the bank to get a loan. A bank that provides the loan can either hold the loan on its balance sheet or syndicate it to a group of similar investors. But there are also other sources of financing, like issuing bonds that is traded on an exchange. However, if you are a small company your go to resource is most often the bank as the public market is not an option. However, if the road to the banks are also closed, one can turn to private credit. Private credit typically involves bilateral negotiation. Investors benefits from relatively high interest, while borrowers benefit from the speed and certainty of execution, agility and customisation.
The largest investors in private credit funds are pension funds, insurance companies, family office, sovereign wealth funds and high net worth individuals.
There is not one private credit strategy. There is an array of strategy that span the capital structure and borrower type, ranging from senior secured loans to junior unsecured credit to loans against specialised assets.
Risks of Private Credit Funds
The Fed has identified several risks to Private Credit Funds. The main risk being a rise in default during an economic downturn for reasons of liquidity of the instrument (due to lack of secondary market) and higher interest rate environment and inflation. Next to the risk for the borrower, private credit can also have financial stability implications as defaults by borrowers can affect the capital position of the institutional investors themselves in a spill-over effect (contractual right to obtain capital committed at any point in time). As banks are also increasingly partnering with private credit funds to fund new deals, these interconnectedness can also impact the financial stability.
The EU Commission acknowledges that Investment funds providing loans can be a source of alternative financing for the real economy. However, the risks linked to the fast-growing private credit market should be properly addressed. It's believed that is vital to address the potential risks that loans originated by Alternative Investment Funds (AIFs) could pose to the broader financial system. To better manage these risks and provide transparency for investors, the rules for AIFMs overseeing loan-originating AIFs are to be standardized across the financial market.
The New EU Rules
The new rules bring about significant changes, enhancing oversight and transparency in loan origination by Alternative Investment Funds (AIFs), while also mitigating risks to financial stability and ensuring investor protection.
Key changes
Loan Origination Process:
Loan origination by Alternative Investment Funds (AIFs) may not always be direct (e.g. it can involve third-party intermediaries or special purpose vehicles). Cases where an AIF or AIFM is involved in structuring loans or defining their characteristics should be considered loan-originating activities to prevent circumvention.
Risk Management and Policies for AIFMs:
AIFMs managing AIFs engaging in loan origination must establish effective policies and procedures for granting loans, assessing credit risk, and monitoring credit portfolios. Policies should be proportionate to the extent of loan origination and reviewed regularly.
Mitigating Interconnectedness and Financial Stability Risks:
AIFMs should diversify risk and adhere to exposure limits when lending to financial institutions. Leverage limits should be imposed on loan-originating AIFs, considering their structure and potential risk of financial instability.
Conflict of Interest and Risk Retention:
AIFMs and their staff should not receive loans from AIFs they manage to prevent conflicts of interest. Loans originated by AIFs must adhere to risk retention requirements when transferred to third parties, and AIFMs should not engage in originate-to-distribute strategies.
Structural Requirements and Liquidity Management:
Closed-ended structures may be required for loan-originating AIFs to mitigate liquidity risks.
Open-ended structures are permissible with stringent liquidity management systems overseen by competent authorities.
ESMA will be granted power to develop regulatory technical standards to determine criteria for maintaining open-ended structures for loan-originating AIFs, considering their nature, liquidity profile, and exposures.
Concluding Remarks
Despite the risks, the market remains attractive as demand for private credit is growing in Europe and US. Goldman Sachs has recently launched an open-end European private credit fund for individual investors. According, to this news-item, as part of its efforts to expand access to alternative assets. The directive will enter into force 20 days after publication in the EU’s official Journal. Member states will have 24 months after the entry into force to transpose the rules into national legislation.
More info:
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD745.pdf
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