The Role Of Alternative Credit Funds In The Non-Bank Lending Environment by AIMA
I am delighted to introduce on behalf of the AIMA Alternative Credit Council (ACC) our new paper, “Financing the Economy.” This research comes at a very important time – as alternative credit funds and the use of non-bank finance becomes increasingly prominent across all aspects of lending.
Non-bank finance is very much part of the mainstream in the US and funds that provide direct lending tend to operate largely in the US. Outside of the US, bank deleveraging in Europe is creating an opportunity for institutional and private investors to expand direct lending to a range of sectors, and there are plenty of new approaches and structures emerging.
Increased activity from capital markets as opposed to lending through traditional bank lending channels has produced material benefits. Included among these are increased market liquidity, a greater diversity of funding sources and a more efficient allocation of risk among investors.
Non-bank lending can greatly mitigate the systemic risk associated with direct lending by banks. Levels of leverage used by funds in their portfolios are close to negligible. Alternative credit funds, typically, are investing on behalf of sophisticated investors who understand and can absorb potential losses. Unlike bank depositors, these investors cannot instantly withdraw their capital, given funds tend to be closed-end in nature. Finally, alternative funds are often specialists in dealing with stressed and distressed assets so complexity is something they are prepared for. Rather than selling assets and collateral in a panic, they are capable of expertly managing default situations.
Amidst historically low interest rates, a dearth of true yield opportunities from investing in fixed income is hampering the ability of pension funds to deliver on their basic objectives. Consequently in recent years, the appetite of institutional investors for private debt exposure has developed aggressively, as the risk-adjusted returns on offer make this one of the most attractive investment strategies of recent years.
Governments acknowledge the need to develop a more diversified lending market in Europe and the role of non-bank lenders in doing this. In its recent Green paper on Europe’s long term financing situation, the EC argues that the reverberations of the financial crisis provides an important opportunity to diversify Europe’s credit markets. Further it confirmed that, in order to truly revive the economy, it will be necessary to improve the blend and overall resilience of different funding sources.
Removing structural barriers to entry in the lending market will increase diversity of supply of credit, boost the resilience of the financial system and drive better outcomes for consumers and businesses.
AIMA’s Alternative Credit Council was established in late 2014 to provide general direction to AIMA’s executive on developments and trends in the alternative credit market. We hope that our combined work will help ensure a sustainable future for this essential sector. Our collaboration starts with this research, which is now the third paper in a series of work that explores the thesis that facilitating greater capital markets, and by association, hedge funds enhances economic growth for the long term. The research is ultimately for the benefit of both policy-makers and market participants, and continues AIMA’s commitment to improving the industry for practitioners and investors alike.
Introduction
The source of funding for the real economy matters. Capital market financing contributes more to economic growth than bank lending by creating opportunities and an economic environment that fosters better economic management and investment in risky but often innovative projects. AIMA’s own research has shown that growing combined stock and bond markets by one-third could fuel a long-term real growth rate in per capita GDP of approximately 20%, as stock and bond market liquidity allows for cost-efficient re-allocation of capital across industries. We’ve decided to go further and look at various components of the capital markets. We examined the role of activist funds in the equity space and have now turned our gaze to the debt markets.
Private debt strategies have grown dramatically in popularity in recent years buoyed by both increased investment from investors into these funds as well as increased demand from smaller businesses for alternative sources of funding.3
Across Europe’s lending landscape, a quiet revolution is taking place in the way companies secure their finance. Amidst tighter banking restrictions and subsequent overall reduced levels of bank lending, the past two years has seen a significant rise in alternative asset managers jumping in to bridge the financing gap via-non bank lending. These alternative lenders consist of a wide range of non-bank institutions with different strategies including private debt, mezzanine finance and distressed debt. Hedge funds have also increased their exposure to this sector through a variety of investment strategies that can be termed, “alternative credit” which include but are not limited to direct lending, private debt, securitisation and capital relief.
As of the end of 2014, figures for Europe reveal over 350 transactions have been completed by 36 alternative lenders in just over 2 years. Deal flow has continued to grow, as the volume of deals done by direct lending funds in Europe increased 43% between 2013 and 2014. It is estimated that there are now around 40 active direct lending funds (up from 18 reported in 2012) and a further 81 new funds out in the market looking to raise £50bn. Increasingly, banks are also teaming up with alternative lenders to provide more flexible structures and there remains a strong role for them in the new lending environment.
Indeed, some of Europe’s largest institutional investors are helping to bridge the financing gap for the SME (Small and Medium Enterprise) sector by investing in alternative credit funds or taking a more direct approach and doing it for themselves. Direct lenders enjoy a growing credit portfolio across a wide range of businesses as well as providing support to a broad variety of infrastructure projects.
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