UK: Travers Smith's Alternative Insights: The Impact And Regulation Of Private Credit Funds (Podcast)

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A regular briefing for the alternative asset management industry.

The direct lending market has changed dramatically since the global financial crisis – and mostly for the better. In 2008, banks were the primary lenders to corporate borrowers; now, private credit funds have a very significant share of the market.

From a regulator's perspective, one big benefit of this trend is the closer alignment between the maturity of the investment in the debt fund and the term of the loans provided to borrowers, reducing the "maturity mismatch" that amplified liquidity problems for banks in 2007/08.

In part, this change was driven by post-crisis regulation: capital requirements for banks made it more expensive for them to lend to unrated corporates, while the AIFMD's pan-EU marketing passport helped private funds. But, before regulators claim the credit, the much heralded European "capital markets union" has not (yet) delivered on its promise – those measures which did emerge mostly added to regulatory burdens, while doing little to improve access to credit in Europe's real economy.

However, despite this generally positive market-led evolution, some commentators have been nervous about its unforeseen consequences, especially when borrowers start to experience financial distress. The trend has also highlighted regulatory fragmentation in Europe, and some gaps. The European legislators therefore earmarked "loan originating funds" as a key focus for the revised Alternative Investment Fund Managers Directive (so-called AIFMD 2). Negotiations on these new rules have almost concluded, and – although there are some important points of concern – the outcome is not as dramatic as some industry insiders had feared.

Of course, the behaviour and characteristics of private debt funds are very different to the banks that previously dominated the market. A recent survey by the Becker Friedman Institute at the University of Chicago found that private credit funds provide mostly cash flow-based loans. The funds say that they "finance companies and leverage levels that banks would not fund". And, although they use some leverage in their funds, it is "appreciably less" than banks. Funds may charge higher interest rates than banks, but are typically willing to take more risk. Indeed, it is also true that many managers now raise "senior" funds which can lend at interest rates closer to those charged by banks.

In the US, and to a lesser extent in Europe, debt funds tend to favour borrowers with a private equity sponsor. Fund managers report that they expect better recovery from distressed deals with a private equity sponsor than those without, in part because the sponsor may inject more capital when liquidity issues arise. Others argue that the aligned objectives and modus operandi of private equity and private credit funds may make it easier for them to work together – and to have "honest conversations" when problems appear. A mutual interest in generating a return over five to ten years may leave more room for solvent restructurings

Reassuringly for policymakers, these differences would not seem to indicate that private credit funds will deliver more insolvencies to the real economy, or that successful restructurings will be harder to pull off.

Managers can point to low default rates for private credit during the pandemic as evidence that their lending practices are sound. It is true that some academics have concerns about the "cov-lite" phenomenon in acquisition finance deals – arguing that no financial maintenance covenants may lead the borrower and sponsor to defer involving the lender in workout discussions – but most private credit lenders still rely on both incurrence and financial maintenance covenants, and use similar techniques to banks to monitor compliance.

Of course, it is early days. The historic benign interest rate environment has not fully tested the ability of private credit funds to manage restructurings effectively. Now that rates have risen, stress is expected to increase in the coming months. It is likely that many private credit funds will recruit more workout specialists or lean more heavily on expert advisers. Most have the resources and incentives to do so.

It is perhaps for all of these reasons that – although AIFMD 2 has addressed loan origination funds – it has focused on investor protection and potential systemic risks, rather than on protections for distressed borrowers and their stakeholders. The final proposals are not especially radical, and – although some of the new constraints seem overly restrictive – should not threaten the business model.

As AIMA's press release on July's provisional political agreement notes, the AIFMD reforms will largely validate existing practices, and may deliver new pan-EU access rights.

For the first time in pan-EU regulation, there will be a definition of loan origination funds – those whose strategy is mainly to originate loans, and those which have originated loans that represent at least 50% of their NAV. Most of those funds will need to implement and maintain policies and procedures for granting credit, assessing credit risk and administering and monitoring their credit portfolio. Concerns about the risk inherent in an "originate to distribute" model have given rise to some new rules on risk retention, and residual maturity mismatch worries are dealt with by rules on leverage, liquidity management and a tougher regime for open ended funds.

For some, the restrictions on open-ended funds and the risk retention rules look rather conservative but, overall, the rules – which will probably take effect in 2026, and include a grandfathering period for some existing funds – are palatable. That could perhaps be seen as a recognition of the significant benefits that private debt funds have delivered to the corporate market.

Regulators will, of course, continue to focus on financial stability and systemic risks, and – although the US Federal Reserve believes that private credit funds are low risk in this regard – the UK's Bank of England and IOSCO are among those who are actively monitoring the situation, which could lead to more regulation in future.

As more alternative asset managers see opportunities in credit investing, further regulation which protects the market and the financial system is inevitable – and, provided it is a proportionate reaction to a careful analysis of emerging risks, is welcome. Industry associations are playing a constructive and supportive role in this regard: last week, for example, AIMA's Alternative Credit Council reported that IOSCO's work cited its research extensively. That ongoing engagement will remain crucial.

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