Funds aren’t just raising money for lending purposes, they’re taking advantage of debt as a bridging facility. and both these markets look set to grow
Last decade’s credit crunch taught us all many things, perhaps the most surprising being the realisation that it’s not money that makes the world go around, it’s debt. The financial crisis and the subsequent global recession were calamitous and, in many minds, were the result of a lending industry that had run out of control.
Given this state of affairs, it’s likely to be something of a surprise to learn that since those dark days and the ensuing Age of Austerity – focused as it is on driving down debt-to-GDP ratios – the total amount of global debt has risen by $57 trillion since 2008. Today it stands at around $200 trillion.
Banks, we are told, are lending less as they seek to comply with Basel II regulations, which require them to maintain higher levels of cash reserves to cover unexpected risks.
According to McKinsey & Company, the European bank funding gap could stand at €1 trillion. Yet the same firm also points out that ‘the ratio of debt to GDP has increased in all advanced economies since 2007’. That means institutions outside of the banking sector are making up the difference.
Alongside the insurance industry, the funds sector has been one of the main areas in which there has been an increase in lending. As a result of this, the Channel Islands have identified an opportunity to encourage loan originating funds (LOF) to base themselves in the islands.
Setting up a LOF
LOFs are usually closed-ended funds that are created to act as lenders to other organisations. Jersey regulations ensure that any LOFs planning to set up in the island don’t provide capital to people or other financial institutions, with the Jersey Financial Services Commission deciding whether or not a fund is granted a licence.
“The beauty of it is that [funds] don’t have the capitalisation issues that banks have,” says Ben Thomason, Managing Partner at Jersey-based Asset Leverage Consultants. “With an underperforming bond market and banks with capitalisation issues, pension funds are looking at the debt market as a great inflation hedge.”
On top of capitalisation requirements, the OECD’s Base Erosion and Profit Shifting measures include regulations that discourage the use of debt as a means to reduce tax liabilities. In the UK, deductions for interest will be capped at a maximum of 30 per cent of a company’s or group’s EBITDA.
There are exceptions, including some for worldwide groups, and given that the main target of the regulations is the use of internal debt to ‘artificially’ inflate deductions, there are likely to be incentives for using third-party debt.
“It should make third-party lending more attractive,” says Mark Savage, Tax Director at BDO Guernsey. “These rules come into force in April next year and they’re likely to drive an increase in fund raising from third parties.”
These new rules are driving the impetus for alternative sources of capital through lending, although the effect is concentrated in particular sectors. “Real estate and general private equity investment into trading companies are the main sectors looking at this,” says Savage. “Infrastructure less so because they have a carve-out from the new tax rules.”
Lending perspective
When it comes to lending, specialist debt funds can play a variety of roles but, according to Andrew Boyce, Partner at Channel Island law firm Carey Olsen, they tend, in the context of larger direct credit mandates, to get involved at mezzanine or junior level, together with a senior traditional bank lender. Direct lending, as an absolute alternative to a bank, occurs more in the mid-market for SME borrowing.
“In the larger direct lending space, specialist debt funds will, in the main, provide mezzanine and junior debt, but they are rarely senior lenders,” says Boyce. “There are many specialist alternative debt providers and a number of the global multi-strategy managers have raised debt/alternative credit funds with commitments upwards of a billion.”
Of course, lending can come in many shapes and sizes. As someone who sources lending for clients, Ben Thomason has seen deals across a vast range. “We’ve done everything from £1 million to several hundred million,” he says, before pointing out that the lending role that funds are playing changes their nature to some degree. “Some funds are looking to compete with investment banks and lend to businesses,” he says. “One such example is Blackstone, which has an exceptional underwriting process and has almost become a challenger bank.”
This makes sense when put into the perspective of the US market, where banks only provide about 20 per cent of all lending. That’s very different to bank-focused Europe, and it means that there’s a very strong alternative lending market.
However, fund lending is on the rise and steadily growing a healthy market share. “Since 2010, the number of funds and the amount being raised for lending has increased and looks set to become 20 to 30 per cent of the [lending] market,” says Daniel Richards, Group Partner at Channel Islands law firm Ogier.
On the flip side
The fallout from the credit crunch may be reshaping the lending scene, with more investment funds providing credit, but there’s another side to the coin – one in which funds are the users of debt. The use of short-term bridging lines (also known as subscription or capital call facilities) in the fund sector is long-established because it enables investment funds to move more quickly to secure the purchase of an asset.
“Competition for quality and value assets is quite fierce,” explains Andrew Boyce. “Often, particularly in the context of an auction, the fund has to demonstrate immediate availability of the purchase monies. A bridging line enables them to do this outside of the time constraints in the normal process of calling money from investors when needed. So the bulk of fund borrowing that we see is for bridging purposes.”
Such facilities can help fund growth because they enable the fund to operate efficiently, being able to secure assets on the strength of the subscription line. For banks, looking at the fund with a view to lending, the appeal is equally strong.
“From a bank perspective, many fund investors are institutional grade investors, so it’s an attractive asset for the bank,” says Daniel Richards.
“The popularity of these facilities is likely to be because the banks see that subscription lines are a strong piece of collateral, whilst fund managers see the operational flexibility these arrangements offer. Managers are realising the usefulness of these facilities and are building them into their planning at the fund structuring stage, whilst they are fundraising.”
Facility size
Unsurprisingly, the size of such facilities can be extensive, ranging from $100 million to $1bn and beyond. As an example, the recently closed Cinven VI fund raised €7bn to invest in European businesses and established a facility alongside the fund in order to facilitate asset purchases through bridge financing.
Whether funds are acting as lenders or are themselves borrowing in order to facilitate their own business, the conventional European view that (beyond the bond markets) debt is the preserve of the banking industry is fast being revised.
Given the vast sums that funds have at their disposal, it isn’t surprising that businesses in the Channel Islands, which have for so long been home to a successful funds sector, are using their expertise to attract LOFs.
At the same time, the advice of legal and funds professionals in the islands is being trusted by fund managers who need to be nimble players in markets that demand speed – a characteristic the banking industry is rarely noted for.
It’s too early to confirm whether Jersey Finance or Guernsey Finance will succeed in attracting LOFs to the islands. However, as long as funds are involved in the debt markets, on whichever side, then the knowledge and expertise available in the Channel Islands should ensure that they remain a jurisdiction of choice for alternative funds of all types.