Debt Funds: sustainable differentiation in a growing market
Spurred by banks’ retrenchment from large areas of lending in the aftermath of the global financial crisis, the growth of loan funds and debt products over the past decade is a classic example of an intelligent industry response to changes in need and circumstance. In filling the gap between small business loans and global billion-dollar debt issues, loan funds managed by hedge funds, private equity firms and asset managers are also meeting the urgent need of institutional investors for non-correlated absolute fixed-income returns in a low interest-rate environment.
Longer established in the US, debt funds have quickly become big business in Europe too, filling the funding vacuum left by banks that have reduced credit exposures to SMEs and other borrowers in response to balance sheet constraints. According to data provider Preqin, assets held by private debt managers quadrupled to almost US$600 billion between 2006 and 2016. Annual returns on closed-ended private debt funds were 9.5% on average in the five years to June 2016, spurring increased allocations. But growth can bring its own challenges, such as greater attention from investors and regulators.
On the one hand, the flood of investment into debt funds is placing upward pressure on valuations, forcing funds to look further along the credit curve for new opportunities. Returns from recently-launched funds are lower than their immediate predecessors, reflecting higher valuations, slower deal flow and fee pressure. Having previously specialised, some private debt fund managers are diversifying, launching new vehicles, with implications for risk management capabilities and operating models, which must be flexible enough to handle a wider range of investments.
"Assets held by private debt managers quadrupled to almost US$600 billion between 2006 and 2016. Annual returns on closed-ended private debt funds were 9.5% on average in the five years to June 2016, spurring increased allocations."
On the other, the growth of private debt funds, and their increasing role in funding across the economy, has prompted calls for greater regulatory oversight. In Europe and beyond, financial regulators – alert the growth of ‘shadow banking’ activities – are monitoring the growth of the sector, including the adequacy of existing reporting requirements, and may in time oblige fund managers to reinforce their internal workflows and data management processes.
Many asset managers are exploring integrated outsourced service propositions, but these may appeal particularly to debt fund managers as the bespoke, non-standard nature of their assets can lead to high headcounts for those conducting all middle- and back-office functions in-house. Across the whole of the finance sector, there is increased pressure on managers to allocate resources where they can create most value. For debt funds, differentiation increasingly lies in origination, credit analysis and risk management.
So long as returns meet expectations, banks continue to retrench, and economic policies continue to promote growth, appetite for debt funds seems likely to increase. But regulatory scrutiny and investor requirements for transparency will mount alongside the increase in AUM. Outsourcing service providers such as BNY Mellon have the financial strength, operational robustness and flexibility to support managers by streamlining workflows, improving data management and enhancing connectivity between systems and counterparties. Debt funds are beginning to grab the headlines and their continued sustainable growth might well be worth a session at FundForum 2018.
For more insights on deb funds, download BNY Mellon's latest white paper, Debt Funds: Sustainable Differentiation in a Growing Market.
BNY Mellon are sponsors at the upcoming FundForum International 2017. Find out more about the world's leading asset management event.
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