The introduction of hybrid funds and regulatory enhancements like ELTIF 2.0 have enabled the retailization of alternative funds, opening up new distribution channels for GPs and managers, and providing diversification and better returns for pension and retail savings funds.
Antonis Anastasiou
Head of Product Development
How the need for enhanced returns and the search for new avenues to raise capital has reshaped the alternative market dynamics
2022 has been a difficult year for capital raising for PE funds showing a decline of 11% in comparison to the 2021 all-time high, according to Preqin data. This has been due to the decrease of LP commitments and Institutional investors reducing their exposure by approximately 3%. Interestingly, a new market has been forming by private individuals and wealth managers demand for diversification and higher returns. As such, GPs and Managers have been forced to seek fresh means of accessing capital to support new vintages.
Mix into this dynamic new regulatory enhancements which have enabled the creation of “Hybrid Funds”. These are effectively the traditional alternative fund strategies we know however incorporating open-ended features and accepting retail investors. This ‘retailisation’ of alternative funds is a term now widely utilized within the industry.
These favorable regulatory adaptations can be a game-changer. For instance, the European Long Term Investment Fund 2 regulation (“ELTIF 2.0”) has been met with positive reactions from both investors and managers.
The new regulatory landscape and ELTIF 2.0
The adoption of the new regime in Europe was completed in April 2023 and comes into force in January 2024. This will replace the existing ELTIF regulation, which has struggled to find its place within the structuring toolbox of Fund Managers as a viable solution. Similar adoptions can also be seen in the rest of the world with the Financial Conduct Authority (FCA) developing the open ended LTAF funds, and in the US defining “accredited investors” which enables certain investors with a level of sophistication warranting a reduced need for protection to invest in alternative products.
The original regime however failed to obtain significant traction with only 83 funds launched. This was predominantly driven by the high level of restrictions which reduced the flexibility that alternative strategies need to flourish.
The much-anticipated ELTIF 2.0 regime has taken a step in the right direction by making it a more attractive vehicle for addressing the “retail market” for alternative asset managers. Key impacts on the PE world include:
Funds can now be structured as open-ended Funds with a minimum annual subscription and redemption opportunity
The removal of the 10 million minimum value threshold for eligible real assets; opening up investment opportunities
The minimum threshold for investments into eligible assets has also been reduced from 70% to 55%
It’s now possible to invest into other EU AIFs and not just other ELTIFs hence liquidity management can also be addressed through AIFs with similar strategies to manage the liquidity requirements
Rules on distribution have enabled the use of a marketing passport across the EU and now allow for retail investors (additional restrictions apply if purely marketed to retail investors)
These “Hybrid Model” setups will require a shift in mentality and operations for both service providers and asset managers:
For Administrators this will require a variety of tools that are able to manage funds with open ended features which were primarily associated to the UCITS world. Additionally, there is a need for systems that can handle portfolio accounting for both illiquid and liquid assets.
For Depositories, the retail regime is geared towards optimal protection of the investors, insofar that only Banks can operate as Depositary for the ELTIF 2.0. This will open the road for specialized banks who will need to blend liquid and illiquid setups together to manage these hybrid funds.
For asset managers there will also be a steep learning curve in managing investors with liquidity requirements that PE firms are unfamiliar with. This could lead to the need for restricted redemptions, highlighting the complexity of incorporating such liquidity measures into their portfolio.
With these challenges comes the added value that such structures benefit:
GPs/Managers by paving the road to new distribution channels reaching both Private and Professional investors and
Pension and retail savings funds seeking diversification and better returns in an asset class which initially could have been out of scope.
The looming AIFMD 2.0 could however incorporate new limitations, but as of now the ELTIF 2.0 has been branded by many as the new UCITS for Alternative Funds.
The Luxembourg advantage and where we go from here
The success that Luxembourg has had over the last 30 years has undoubtedly enabled the country to become one of the most established Fund domiciles globally. The initial drive for this success was through the retail funds world in UCITS. The adoption of the AIFMD in 2013 has opened the space for alternative managers to replicate their strategies and develop a market for professional and institutional investors as well. This has further solidified Luxembourg as the go-to country for the launch and management of Funds.
The level of stability, history and services available in Luxembourg also makes it a prime mover in the domicile of these new Hybrid ELTIF 2.0 Funds. It offers both the regulatory supervision and comfort for investors as well as a plethora of established names in service providers which have adapted over the years to meet clients’ and investors’ needs.
Additionally, within its own structuring toolbox, Luxembourg already has the approved UCI Part II Funds (17 Dec 2010 Law). These funds offer eligibility in all types of assets, however, distribution can only be to professional investors but could accept any type of investor into the fund. In theory, therefore, retail investors could also enter the fund.
With a broader product line and willingness to service these type of hybrid funds as shown by the adoption of the original ELTIF regime, Luxembourg clearly places itself as the primary location for the development of the ELTIF 2.0 Funds. This is further enhanced with a booming retail and alternative offering, a successful history, readily available staff, and first-class service providers. Ultimately, it has the expertise for the development and success of the reutilization of the alternative Fund Industry.
From chaos to harmony: How Alter Domus’ data science team extracts value from corporate financial statements
Alter Domus’ financial data spreading service leverages Machine Learning, automation, and in-house domain expertise to rapidly deliver digitized borrower-level financial statements for the alternative investment industry. Amy Wu of our data science team explains the process and why partnering with Alter Domus is a difference maker.
Amy Wu
Head of Data Operations
How do we define financial spreading?
Financial spreading is the process of taking bespoke financial statements and representing the data in a standard, structured format. The key thing to note is that since private market financial statements have variable reporting formats, financials must be standardized first before undergoing credit analysis. This requires an analyst to manually populate a structured template with the information from the tables within a financial statement which can take a huge amount of time to complete.
Can this manual work be outsourced?
Yes, private debt managers will often outsource this work to save on costs. However, we’ve spoken to many chief operating officers and chief risk officers in the last couple of years and the message we’ve heard is that turnaround times are not generally improved via outsourcing; they’ve also highlighted how credit analysts often need to manually review and correct errors in outsourced work to ensure that the spreading has been done correctly.
How is partnering with Alter Domus to perform data extraction different?
A good question. Alter Domus’ Digitize – Corporate Financials solution uses machine learning and automation to significantly reduce the time to digitize financial information and ensures high-quality, accurate data by leveraging in-house experts for quality checks.
It’s important to emphasize the human element here. Computers may be fast, but they need some human help to ensure that the spreading is performed correctly. At the end of the day, we’re generally dealing with unstructured original documents in non-universal formats, and that’s where our dedicated data science team steps in to work in tandem with our market leading tech.
It’s worth highlighting that unlike general machine learning models, Alter Domus’ machine learning capability is trained on millions of financial statements to identify tables, columns, and fields and extract data from tables.
The client’s raw data is extracted from PDF formats using advanced Deep Learning models. A manual raw data extraction quality check is put in place to verify the extracted results and provide a feedback loop back to the machine in a continuous, supervised learning process. If an Excel file is provided, then the data does not need to be processed by this initial step as the raw data is already digitized.
So, the data is ingested and digitized. What happens then?
After the extraction process, the data is normalized, aggregated, and checked through automated QA testing, after which it’s then validated by an in-house credit analyst. This as-reported output flows into two views. Firstly, a Management Account View and, secondly, a Universal View. The Management Account View is the aggregated time series data for a single borrower based on the reported line items from the original raw PDF data. This view is different among borrowers. The Universal View is the aggregated time series data in the Alter Domus standardized template, which is the same across borrowers.
The conversion into the Universal View is done by applying Alter Domus’ rule set to automatically map reported line items into corresponding categories. If the client has their own custom template, Alter Domus will work with the client to define their own category definitions to create their own custom mapping rules. Once again, our data science team will always perform a last QA check before delivering the final output.
Ultimately, where other solutions simply provide clients with raw data output, our system and methodology provide users with tailored, customized data that can be seamlessly deployed to whatever downstream systems – from portfolio or asset monitoring platforms to risk modelling and reporting tools. The point is that data is now primed and ready for deeper analysis.
What does this mean for our clients?
Effectively, it means they can import the formatted financials to their downstream systems the day after the source documents have been uploaded instead of waiting up to 3 days for a standard outsourcer to do the same work. That’s a significant difference in time and allows our client and its teams to focus on higher-value tasks.
Digitize – Corporate Financials goes beyond simply providing a digital representation of the borrower financial information, which is where most outsource companies service finishes. To provide consistency for comparing data over time and across borrowers, all values are converted from reported units to actual units during the automated process. In addition, the service automatically processes the data restatement from pro forma reports when available and provides period over period change information to identify reporting outliers.
We think having humans and machines working in lockstep is essential for us to speedily provide our clients with accurate data that’s been honed and harmonized to meet the exacting needs of their specific organization.
Interested in finding out how we can help you achieve a new level of data sophistication? Get in touch today to speak with a member of our Sales Team.
Co-sourcing, lift-outs help fund managers thrive amid change
Business as usual may have a nice ring to it, but for alternative investment fund managers, there’s really no such thing as “usual.”
Sandra Legrand
Regional Executive Europe & Asia Pacific
The market’s always in flux, regulatory requirements can seem like moving targets, and investor demands for more information, more transparency, and more timely reporting can stress even the best in-house staff and systems. And that’s not even to mention the effect growth, spin-offs, mergers, and acquisitions have on daily operations.
Trying to keep up with it all can drain resources and shift the focus away from strategy and returns, which is why so many fund managers are outsourcing administrative responsibilities to reduce day-to-day burdens.
Yet even outsourcing is evolving. Long gone are the days of task-oriented, commoditized relationships with multiple providers, each furnishing different ancillary services. They’ve been replaced by deep partnerships with asset class specialists — experts who can provide all the jurisdictional, operational, and systems support a fund manager needs across the globe.
And while that’s a highly successful model, still another concept is emerging, driven by the need for real-time data. It’s called co-sourcing, and it’s a hybrid way for fund managers and administrators to work together.
Co-sourcing ensures data control
Co-sourcing exists at the intersection of insourcing and outsourcing. Under the co-sourcing model, the administrator handles the day-to-day back- and middle-office operational activities while the fund manager retains ownership and control of their in-house technology and data solutions. That reduces the back-and-forth of information between the administrator and fund manager, meaning the fund manager can access the data in real time to speed decision-making and respond more quickly to investor requests. The administrator can also retrieve the information required to perform stakeholder management functions, but data confidentiality, integrity, and security remain firmly in the hands of the fund manager.
Lift-outs: Lower expenses, same trusted talent
As fund managers grow their investment franchises, meeting data demands can become increasingly challenging, to the point where it takes nearly continuous reinvestment in technology and in-house operations just to stay even. But making non-stop capital expenditures isn’t always feasible or attractive, and neither is shouldering rising human resource costs.
As an alternative, some administrators will conduct a “lift-out” of the fund manager’s operational teams, making them their own employees. Although the staff now fall under the administrator’s overhead, they remain completely dedicated to the fund and its activities. In other words, there’s no loss of talent or attention, but the cost center changes, and the fund manager is freed from the complexity of managing a back or middle office.
Staying a step ahead
Choosing the right fund administrator is a decision no one takes lightly; there’s just too much at stake. But ultimately, a good administrator will provide white-glove service; add value to the portfolio, risk management, and investor teams; and constantly upgrade their technology.
Most of all, they’ll be innovators who know how to stay ahead of the market and the industry, making the concept of “business as usual” not so unusual in the end.
Whether transacting on the secondaries market or adapting to new regulations, having access to the right expertise, data and analytics capabilities will help investors keep pace with change, says Alter Domus CEO Doug Hart
Doug Hart
Chief Executive Officer
How robust is the LP-led secondaries market right now?
The secondaries market is more robust than we have ever seen it. Capital raises are up – there was a 30 percent jump in secondaries fundraising in the first half of this year, versus 2022. On a relative basis, the jump is even more pronounced, seeing as the overall fundraising market for private equity is pretty flat.
Secondaries had always been a single-digit percentage of the overall marketplace, but now we are seeing it move into the low double digits. Furthermore, LPs are now leading the majority of secondaries deals, which is quite different to the situation we have seen in the past few years.
This is a logical result from the market dynamics that are playing out. In a prolonged low fundraising marketplace, we are seeing concentrations build within LP portfolios due to fewer new funds being launched. Distributions have also slowed in the last 12-18 months, so there is a significant change in the return perspective – we are going from more of an IRR-led model, to a distributed to paid-in capital or a return on capital model.
Generally, this is a space LPs want to be in, while ensuring they have proper asset allocation across secondaries and are not overly exposed. In addition, they want to be relevant players in the marketplace.
Can the secondaries market retain momentum as the broader market rebounds?
This year we’ve seen major market players raising capital for massive, multi-billion-dollar secondaries-specific funds, with many longer-term forecasts indicating that the market will continue to grow and become a bigger piece of the private equity landscape. The volume of actual secondaries transactions may be influenced by what happens with the inflationary environment and interest rates, which have caused headwinds for private equity over the last 18 months.
But there are two other factors to consider here, the first being that a secondaries play isn’t the blunt tool of its earlier years, when it was just used to generate short-term liquidity. This is a market and a strategy that have really come to maturation, and LPs are increasingly using what’s now a very nuanced instrument to actively help manage the composition of their portfolios.
Secondly, the increase in secondaries volumes and activity is attracting a lot of talent in the marketplace today – there’s been huge industry investment in standing up dedicated, specialist secondaries teams. From an Alter Domus fund administration perspective, some of the best individuals in our teams are moving into this space to continue to take on demand and support onboarding requirements for secondaries, which involve more reporting, and more detail than ever before.
What this all indicates is there’s now a very defined ecosystem around the secondaries market, and we are unlikely to see all that talent and creativity suddenly shift away from it – secondaries will likely continue to play a vital role in LPs’ strategic investment plans.
How do you see this ecosystem around secondaries evolving?
There is more demand on reporting and more demand on LP transfer process efficiency. In the past, the somewhat bespoke nature of secondaries allowed for much longer timelines for investor onboarding. Today, those timelines are truncated to the point where processes are advanced quickly to meet the timelines for the new marketplace velocity.
One aspect of that, as we look at the ecosystem’s evolution, is that there are new participants coming into the marketplace around data and analytics. There is a body of data now and more standardization. This ecosystem is allowing data and analytics, tracking, forecasting and modeling to become much more advanced. Investors can come in and have confidence to position their portfolios in an allocation structure that is more nuanced, or more advanced, than in a marketplace without data and analytics capabilities.
Turning to private markets more broadly, what are the main regulatory changes that LPs and GPs should be aware of in the next year?
The biggest change in Europe is the new European Long-Term Investment Funds Regulation (ELTIF 2.0), which comes into force in January 2024. This is going to expand the permissible investments that can be brought into a portfolio. There will be a lot less prescription in the regulation, which means there is more scope for creativity in how a portfolio is constructed. It will be interesting to see how that plays out.
The big headline that we are focused on is the democratization of closed-end vehicles. A lot of private market assets historically have not been open to retail investors, and ELTIF 2.0 will address that. Almost overnight, we will see retail investors have an entry point into private markets.
The US market, meanwhile, has historically been less regulated. There are more opportunities for high-net-worth individuals and retail investors to invest in private market funds. But the US Securities and Exchange Commission recently decided to strengthen regulation of private fund advisers, largely because it wants to protect retail investors. It is going to require a lot more disclosure, reporting and real-time assessment of the investors coming into the portfolio and the portfolio’s ability to provide sufficient liquidity and information to that investor.
There are various opinions on these rules, and they are being challenged quite vigorously in the courts. From our perspective, we are excited by the opportunity to open up private markets to a large channel of new investors. We are tracking the situation closely and are prepared to be on the forefront to ensure those investors come into an information-rich environment.
What are the challenges to supporting clients across both Europe and the US, given the complexities of the regulatory environments?
Very few firms have the size and the scale to support a complex, complete understanding of both markets. The regulatory environments and the reporting requirements are both complex, and the complexity is doubled if you need to pivot between the two. Most of our clients are naturally more familiar with their home region and look for support from service providers like us when they operate in other jurisdictions.
We have always had the ethos of being where our clients need us to be. The key thing is to find the right talent in different markets who have knowledge of the local regulations and expertise in operating in the private markets.
The search for new capital and the emergence of hybrid funds
In the second article of a four-part series on raising capital in Europe, we explore the factors that have been driving the emergence of hybrid funds. Insights come from Antonis Anastasiou, Group Head of Product Development, and Conor O’Callaghan, Head of AIFM Ireland.
The alternatives landscape is changing. While once reserved for institutional investors, pension funds and high-net-worth individuals, it is now opening its doors through the democratisation of alternative funds. A coming together of worlds so to speak, which are combining and innovating to create a hybrid world of liquid and illiquid funds, which are both now open to individual investors.
There are a number of trends and drivers in the market that have been behind the emergence of these hybrid funds. Firstly, monetary tightening is resulting in institutional money pulling back from the market. Private asset AUM continues to grow, however traditional LPs are reducing new commitments with global fundraising declining by c. 10% in 2022, followed by further declines so far in 2023 – GPs have been forced to pursue alternative sources of capital to support fundraising.
At the same time, a new demographic of investor is seeking to gain access to such markets. While private asset funds have long been used by institutional investors, due to regulatory restrictions, private individuals have been limited in their ability to allocate funds to the asset class. As this portion of the market is becoming more sophisticated and educated, individuals’ appetite for private asset funds is growing as they recognize that gives them more options to build a more diversified portfolio. While allocations by this investor group accounted for 9% of Alternative AUM in 2017, that climbed to 16% in 2022, a 165% increase in AUM.
Hybrid funds have the traditional alternative fund strategies, while also incorporating open-end fund features and accepting individual investors, with the goal of bridging the gap between individual investors and private assets. Within the industry, that’s often described as the ‘democratization’ of alternative funds, with Bain forecasting that individual wealth allocated to alternative investments will increase 12% annually over the next decade while institutional capital will grow by 8% annually over the same period. We have seen how large managers are directing their funds towards retail clients, with Blackstone expanding retail capital from $200 billion to $500 billion, while KKR are looking to raise up to 50 per cent of their new capital from private wealth and Apollo are looking to raise $50 billion in retail capital from 2022-26.
New regulations pulling in the same direction as the market
Regulation is at the forefront of the market’s needs and is allowing the market to deliver these types of products to individual investors at the very time it’s looking to do so.
In the UK, the Financial Conduct Authority has developed the open-ended Long-Term Asset Funds, or LTAFs, while in the US the term ‘accredited investors’ has been defined, enabling sophisticated investors who have a reduced need for protection to invest in alternative products. In Europe, welcomed enhancements to the European Long-Term Investment Fund, or ELTIF, will go live in January 2024, and this will replace the existing ELTIF regime. We will be exploring ELTIF 2.0 in greater detail in the next two articles in the series.
Now is the time to take advantage
This new regulatory landscape is providing a toolbox for managers, enabling them to develop products and expertise for the retail network. At Alter Domus, we are already working with managers to capitalize on these developments while overcoming the challenges that come with it, which we will be looking at in the fourth and final article.
Variation in BDC portfolios can offer investors opportunities to better manage risk and return
Rudolph Bunja
Head of Portfolio Credit Risk
Steve Kernytsky
Manager, Quantitative Analytics
Nick Harris
Junior Data Analyst
Summary
Private credit markets continue to be an important source of funding within the leveraged loan universe. This is especially the case for smaller to middle-sized companies, those with EBITDA of roughly $10mln-$250mln. Non-bank lenders have emerged as a growing source to funding to these borrowers through a variety of platforms.
Examples of these alternatives include direct lenders, closed-end funds, to a lesser extent, collateralized loan obligations (CLOs), which generally fund larger and broadly syndicated loans (BSL), and last but not least, business development companies (BDCs). We have recently turned our analytical attention to BDCs as they provide both institutional and retail investors an opportunity to participate in the small and middle market lending asset class and as many are publicly traded.
Although BDCs typically invest in senior secured loans to smaller and middle-sized U.S. borrowers, the portfolio compositions can vary in many dimensions across BDCs, and in some cases quite significantly. Our analysis has highlighted key elements within the portfolios that would indicate the degree of correlation and hence effect the variance in the performance of a BDC’s returns (or losses) in two dimensions – issuers and industry.
These differences are particularly important for BDC investors (or lenders) as performance metrics would be further magnified due to the leverage that BDCs employ to finance themselves, similarly to CLOs, many closed-end funds and other leveraged investment vehicles. In essence, the relative risk/return profiles for these market participants can be more exposed to “fatter-tails” in the distribution of returns of the underlying portfolio due to less diversification (i.e., potential for greater volatility) – or conversely smoother and more predictable risk/return profiles due to greater diversification within the BDC.
Key performance drivers are related to the overall portfolio diversification of the BDC based on its concentrated exposure of investments made to unique borrower/issuers and industries/sectors, which are the focus of this paper, amongst other factors. We demonstrate through observations, which are based on publicly available information, that clearly indicate significant differences of diversification across BDC portfolios. However, this variation of portfolio composition also provides investors (or lenders) opportunities to better manage across the risk/return and portfolio diversification spectrums.
BDCs – brief overview
The US Congress initially established BDCs in the 1980s to offer an alternative source of funding to developing smaller and middle-sized companies. BDCs are generally subject to the same rules and regulations that apply to US regulated mutual funds – the Investment Company Act of 1940 and the Internal Revenue Code of 1986 for tax purposes.
BDCs are typically leveraged, subject to a maximum amount, with financing typically based on a combination of credit facilities and term debt. BDCs are subject to certain investment criteria (e.g., minimum percentage of investments consisting of smaller U.S. companies) and are required to pass through at least 90% of earned income.
The underlying portfolios typically comprise of first-lien senior secured loans to private corporate borrowers – other possible investment strategies may be around subordinated loans, mezzanine debt, special situations, and distressed debt, amongst others.
The investments are managed by asset managers with extensive expertise and operations capacity in this asset class where, in many cases, the manager may already participate outside of the BDC as direct lenders, private equity sponsors and/or manage other types of vehicles (e.g., CLOs, private accounts, closed-end funds).
In a previous analysis, we highlighted some key differences between private credit and BSL as well as factors for investors to consider. BDCs are generally substantially weighted towards middle market and smaller company lending although there are some BDCs with notable CLO/BSL exposure.
Those BDCs that are publicly traded not only offer liquidity to investors but also a great amount of transparency. For example, like other public companies, they are required to provide quarterly and annual reports. These reports make available to the public numerous detailed information related to the underlying portfolio and is the primary source of information our observations are based on.
It should be acknowledged that these are point-in-time snapshots of the portfolio and could change over time as BDCs are going concerns and actively managed. However, they do provide valuable insight into the manager’s lending/investment philosophy, and we believe our conclusions and findings are generally valid across time. Market participants should view this as an example of portfolio variation across the public BDC spectrum at a given point-in-time.
Comparing diversification across BDCs – key observations
We selected a sample of 32 BDCs to compare amongst the 40+ that are publicly traded (see Appendix). These examples were chosen to clearly demonstrate how the composition of the portfolios can vary significantly across BDCs. In this case, the focus is with respect to investment diversification as reflected by the distribution of borrower/issuer and industry/sector concentration levels. Other diversification benchmarks, which is outside the scope of this paper, could include investment strategy, credit risk, geography, currency, seniority of debt, asset class, level of affiliation, etc.
See Exhibits 1-4 below illustrating various concentration statistics followed by noteworthy observations. Note that the percentages and amounts of the respective portfolios are based on fair market value in USD as reported, in most cases as of the most recent calendar year-end. In addition, we excluded any investments that were in cash (or its equivalents) or had a fair market value of zero.
Borrower/issuer concentration
Exhibit 1: Top Seven Borrower/Issuer Concentrations vs. Average Concentration
In many instances, portfolios tend to be fairly concentrated within the largest few exposures, but relatively granular with the remainder. See Exhibit 1 above illustrating that the largest seven borrowers/issuers range from approximately 10% to about half of a given portfolio.
Also, BDC portfolios can consist of less than 30 investments allocated to unique borrowers/issuers to more than 300. The exhibit also illustrates the level of average borrower/issuer concentration in the portfolio that provides additional insight into the degree of granularity across the portfolio.
It is important to note that, in several BDCs, aside from significant exposures to general corporate borrowers, some of the largest investments are allocated to pools of investments (or ‘funds’). These funds can consist of an underlying portfolio of credits financing private corporate borrowers, real-estate, or equipment as examples.
They can be managed by the same manager of the BDC, a joint venture with the BDC manager, or another fund altogether (e.g., CLO, another BDC, closed-end fund). The latter would likely be managed by a separate entity.
In some cases, these funds can be around 10% or even greater than 20% of the BDC portfolio. Obviously, one can argue that these investment allocations indicate more diversification than one made to a single corporate borrower.
However, the degree of diversification would depend on exactly what investments underly the fund and its individual exposures versus the rest of the BDC portfolio (e.g., borrower overlap). In addition, for an investment in a fund that is levered, like a CLO, it would also depend on what seniority position the investment is within the capital structure (e.g., senior, mezzanine, equity).
Industry/sector concentration
Comparing industry/sector exposures across BDC portfolios is a bit of a challenge since there is no standardized industry reporting classification taxonomy used across the BDC market. Some BDCs classify industries more broadly across their investments while others classify them on a more granular level.
To further complicate matters, as mentioned earlier, certain BDCs have investments that are in funds. It is more difficult to determine industry concentrations in those cases unless one can look through to the underlying investments within those portfolios. For example, it may be unlikely that a CLO portfolio has any significant borrower overlap with the rest of the BDC portfolio since they typically comprise of BSL and that they are often managed independently.
However, this may not necessarily be the case with respect to industries/sectors. In which case, market participants would need to rely on their own assessment based on information made available. Nonetheless, determining diversification across funds or CLO portfolios within a BDC portfolio is beyond the scope of this paper as it can depend on many factors (comparable to those presented here).
Therefore, to make the BDCs more comparable in this respect, with judgement, we mapped the industry classifications that each BDC reported for each investment to a standard group of industry categories.
Exhibit 2: Top Three Industry/Sector Concentration vs. Average Concentration
Initial observations indicate that BDC portfolios are generally concentrated amongst several industries. See Exhibit 2 above illustrating that the largest three exposures typically exceed 40% and in some cases exceed 70% of the overall portfolio. Additionally, the total number of industries represented across a portfolio range from less than 10 to more than 20.
Again, note our earlier comments as some of the top industry classifications may include investments in funds consisting of underlying portfolios. As with Exhibit 1, the exhibit also illustrates the level of average industry/sector concentration in the portfolio providing additional insight as to the granularity across the portfolio.
Exhibit 3: Common Industry/Sector Concentrations Across BDCs
It is also noteworthy that several industries commonly appear across the BDCs (see Exhibit 3 above). Specifically, these industries are related to high-tech, healthcare & pharmaceuticals, business services, and finance. Furthermore, in many cases, these industries are within the top three most concentrated (see Exhibit 2).
This is a particularly important factor for those investors (or lenders) that have exposures to a portfolio of BDCs when assessing the correlation across their investments as these industries represent some of the largest investments across the universe of BDC portfolios, in terms of both the number of individual investments and fair market value.
Of note, however, these industries could be diversified in their own right into finer industries that would imply lower correlation – for example, within ‘high-tech’ there are companies that focus on educational software, construction technology, cyber, electronics, green technology, health-tech, manufacturing technology, etc.
Not surprisingly, however, the most concentrated BDC portfolios can be less correlated with others since they may have minimal exposure to (or exclude) many industries. This is obviously another key factor for those market participants that allocate (or monitor) investments across BDCs as it can provide an opportunity for additional diversification and/or targeted allocations to certain industries in the private markets.
Asset type/seniority concentration
While we won’t delve into detail for this article, but may be explored further in future Alter Domus research, it is worthwhile noting that the type of and/or seniority level of the investments can vary across BDCs. See Exhibit 4 below for concentration levels across various asset classes as reported by the BDC. We grouped certain types together as they can be considered as other and with relatively small exposures with the exception of CLOs (particularly the most subordinated), which can be significant.
Exhibit 4: Asset type/seniority concentration
Exhibit 4 shows that debt is commonly the most significant portion of the portfolios. This is to be expected as BDCs typically extend credit to corporate borrowers usually in the form of senior secured loans. Within the debt spectrum, these can vary from senior secured loans that are on a first or second-lien basis to those that are unsecured or in the form of notes.
As mentioned earlier, BDCs can offer financing to a single borrower across the capital structure (e.g., senior secured, mezzanine, equity) depending on the BDC manager’s financing strategy. The combination may explain some of the significant equity exposure. The equity exposure can be an investment in a levered fund as well.
Conclusion
Non-bank lenders, within the private credit market, have been an important alternative source of loan funding for smaller to middle-sized U.S. companies through various platforms (e.g., direct lenders, closed-end funds, BDCs). BDCs are particularly worthy of attention since they offer a spectrum of investors an opportunity to participate in this lending asset class and as many are publicly traded.
Portfolio compositions can vary quite significantly across BDCs even though BDCs typically consist of leveraged senior secured loans extended to smaller and middle-sized U.S. borrowers. These differences across BDCs offer investors a menu of risk/return profiles to suit their needs.
We presented our observations on variations in diversification across BDC portfolios based on an evaluation of elements that are key indicators to the overall level of diversification, with an emphasis on concentrations to unique borrower/issuers and industries/sectors.
In conclusion, our analysis indicates significant differences of diversification across BDC portfolios, which provides investors opportunities to better manage across the risk/return and portfolio diversification spectrums.
Testing the market: Pre-marketing – a compelling solution to capital raising in the EU
In the first article in a four-part series on raising capital in Europe, we look at why non-EU fund managers should be exploring pre-marketing along with other upcoming regulatory changes shifting the alternative landscape, namely ELTIF 2.0 and the democratization of alternative funds. Insights come from Antonis Anastasiou, Group Head of Product Development, and Conor O’Callaghan, Head of AIFM Ireland.
There seems to be a misconception among non-EU alternative fund managers that Europe is a complex and closed market for raising fresh capital.
Those managers are being advised that reverse solicitation is no longer an option following the August 2021 changes to the AIFMD Marketing Rules. This is rightly so in our opinion, as it should never have been considered a marketing strategy in the first place. That being said, the knock-on effect is that they are no longer actively considering raising capital in Europe.
What is clear to us is that such managers aren’t being fully made aware that there are other marketing solutions for their funds. ‘If reverse solicitation is no longer an option,’ they say to us, ‘why would I spend the time and effort to try raise capital in Europe?’
The immediate answer we give to that question: pre-marketing.
Once we raise the subject of pre-marketing – and how it is a far more cost-efficient and timely way of engaging with prospective investors before launching a fund – we sense that managers become very interested. It’s at that point that they often start to reconsider what opportunities there may be across Europe.
Clarity for fund managers: the rules about pre-marketing
The current EU rules around the pre-marketing of alternative investment funds have been live since August 2021. Previously, what constituted pre-marketing – which was sometimes known as ‘soft marketing’ – hadn’t been universally defined across the EU member states. Different rules in different jurisdictions meant the process was considerably more complex, with fund managers often needing legal advice about what was allowed in each country.
Much of that complexity has been removed. The introduction of harmonized, EU-wide, pre-marketing rules has provided greater clarity for fund managers who are looking to navigate this market and need to understand what preliminary promotional activities are permitted before establishing a fund.
What is permitted: the definition of pre-marketing in Europe
Across all EU member states, pre-marketing is defined as the provision of information on investment ideas and strategies, as well as the track record of the manager. That information is provided by, the authorised representative, to investors in the EU to test their interest in a fund that has not yet been established or has been established but has not at this stage been notified for active marketing. To comply with the rules, pre-marketing must not include information that could amount to an offer or a placement to the investor.
To engage into pre-marketing discussions with potential investors, alternative managers simply need to select an AIFM they would like to work with. In-turn the AIFM files a notification with their local regulator on behalf of the manager. The notification details the intent to launch a fund and their wish to initiate discussions with potential investors in the countries listed in the notification (passporting rights).
Cost efficient and faster: why fund managers are using pre-marketing
Fund managers are finding that with pre-marketing, the previous cost barriers to initiate discussions and test the market – which could run into hundreds of thousands of Euros – are no longer there. They’re able to gauge investor interest first before incurring the expense of launching the fund.
Pre-marketing is also faster. Previously, managers had to first go through the process of establishing the fund or vehicle. Then they had to appoint service providers including the AIFM, who in turn had to notify the regulator in each of the countries in which they wanted to commence marketing. Obtaining regulatory approval from all the relevant authorities could take up to an additional 21 days following launch of the fund.
Under the current rules, that’s no longer necessary. A Pre-marketing arrangement takes just a couple of weeks to set up. All that is needed is the submission of notification to the relevant regulator, but it does not require formal approval. Once activated you’re able to test the appetite for your strategy with investors across Europe. Once you’re confident to proceed and you feel you have sufficient interest, you can go ahead and establish your fund. This could also be a process which can run in parallel with pre-marketing. This ensures there is not time lag between first close and the launch of the fund.
Further regulatory enhancements and the emergence of ELTIF 2.0
Any fund manager who is considering raising capital in Europe should be aware that pre-marketing is only permitted when approaching professional or well-informed investors. However, these rules will also apply to the new adaptation of the existing European Long Term Investment Fund regime, known as ELTIF 2.0, when it comes into effect in January next year. These enhancements will in addition open access to a retail network eligible to invest into the new ELTIF 2.0 funds.
When used in conjunction with the passporting rights that come with a Pre-marketing arrangement, a manager can register in one EU member state, to pre-market freely across all member states, and now reach a broader range of potential investors while minimising initial outlay. This new market of private individuals and wealth managers, comes at a time when there has been a decline in commitments from traditional LPs and institutional investors to GPs and managers.
Over the remaining three articles in this four-part series, we will take you through the new adaptations of the ELTIF 2.0 framework. We will also cover key considerations you may wish to address when looking to raise capital in Europe and how we are preparing to serve our clients as the fundraising landscape in Europe evolves.
In the dynamic landscape of fund administration, co-sourcing emerges as a strategic solution to meeting increasing investor demands for precision and real-time data.
Jessica Mead
Regional Executive North America
With the number of fund administrator firms growing by 10% since 2018, how can companies stand out in an increasingly crowded market to provide added value to their clients?
For Jessica Mead, Regional Executive North America at Alter Domus, the answer lies in successfully blending technology with human expertise, with co-sourcing an increasingly popular way to marry the two.
Jessica shared her thoughts during a service provider webinar Oct. 25 sponsored by investment data company Preqin, where she joined panelists Peter Naismith, a partner in law firm Schulte Roth & Zabel, and Meera Savjani, Fund CFO at Arrow Capital.
Co-sourcing model: integrating expertise and technology
While information has always been key to strategic decision-making, Jessica said that GPs are under increased pressure from their investors to provide more precise and transparent data, and to do it in real-time. Service providers who can meet those demands are going to be more successful, she believes, and co-sourcing may be a way to get there.
In the co-sourcing model, the GP maintains ownership of their in-house IT system and data while their service provider works in the environment alongside other departments. Co-sourcing helps GPs meet the shortened reporting timelines requested by investors yet maintain, or even improve, data accuracy.
It can also improve standardization, Jessica said.
“While LPs’ demands can make standardized reporting difficult to achieve, co-sourcing with an experienced service provider means GPs can still achieve industry best practice standards while meeting customized reporting demands,” Jessica explained.
As well as technological expertise, co-sourcing offers another important and complementary client benefit – systems and sectoral expertise. Marrying technology with this expertise, as well as finding the right culture fit, is at the heart of the co-sourcing concept.
In response to Preqin’s claim that AI is being included in due diligence questionnaires for fund administration services, Jessica said she hasn’t seen much of that so far. She noted that Alter Domus is already ahead of the trend by developing tools in-house across the company’s suite of services to streamline some of the more repetitive functions. She also noted that, by automating more and more areas of fund admin, firms will not only need to provide that data output in real time to clients, they will also need to offer value-added expertise to stand out from the pack.
Finally, looking ahead to 2024, Jessica predicted there will be further consolidation in both the service provider and the manager space.
Alter Domus wins Best Fund Administrator – Private Credit award
The Private Equity Wire European Credit Awards ceremony took place on 26th October in London.
Alter Domus
We are delighted to have won “Best Fund Administrator – Private Credit” at the Private Equity Wire Private Credit European Awards 2023 in London. This award is the culmination of our efforts over the last ten years and is demonstrated by the fact that today we administer $200bn of European private debt assets.
With our highly experienced European team, we are uniquely positioned to support clients as they look to address the complexities of private debt strategies. The expertise of our people, our integrated service offering, plus our market-leading technology solutions mean we are truly able to offer the advantage in alternatives.
A big thank you to the Bloomberg-selected credit fund managers who voted for us. And a big congratulations to our team!
Maximizing technology capabilities to enhance decision-making
Technology is part of a solution that involves bringing together managers, investors, and back-office administrators to make better decisions and improve investment performance, argues Gus Harris, Head of Data and Analytics at Alter Domus
Gus Harris
Head of Data and Analytics
Real estate businesses, like those in other sectors, know that their performance will increasingly depend on their ability to gather and analyze data. But few have yet mastered the processes, and identified the tools, that will allow them to do so in a cost-effective manner.
A common pitfall is to begin with the assumption that the answer is solely a matter of buying or building technology platforms, observes Gus Harris, head of data and analytics at fund administrator Alter Domus. Instead, he argues, technology should be viewed as an enabler for the smooth flow of data from its source to the decision-makers that utilize it, a process that can be facilitated by a trusted back-office provider.
What are the most pressing challenges for global investment managers’ and investors’ back and middle offices?
The market is expanding. As portfolios grow, managing those portfolios becomes more complicated. Allocating to a wider variety of alternative investment strategies, the scale in AUM that brings, and the intricacies of managing such assets internationally for a diversified client base that demands ever more nuanced risk-return profiles from their investments, increases cost and complexity.
Some of the data flowing back to investors from their portfolios may have been processed manually in the past, but those solutions are just not scalable today. Solutions that may have worked when asset managers had $1 billion under management are no longer effective when they have $30 billion or $50 billion.
Meanwhile, technology has matured significantly. The ability to automate, and to analyze data more efficiently has been greatly facilitated over the past 10 years, and now it is growing exponentially with the introduction of AI and other cutting-edge technologies. If managers fail to harness that capability, it affects their ability to grow scale, because the cost of doing so becomes exorbitant. In addition, if they are too expensive compared to their peers, investors will turn to more efficient managers that can provide them with more and better-quality information.
Asset managers that can charge lower fees and provide better data because they have smartly automated their operations will win out. We have reached the point where managing data is almost an existential issue for managers that want to grow scale.
What are the key considerations for managers seeking to take control of their data?
The first is accuracy and completeness. Data from different sources and contexts must be normalized so that it is directly comparable. It must also be gathered in a timely manner. The second challenge is scale. Whatever data solution a manager has in place needs to be able to scale vertically, so that they can add on more of what they want in a cost-efficient and timely way. It also needs to be able to scale horizontally, as the manager invests in new types of instruments. One of the current features of the market is how many new flavors of investment solution are being added all the time.
A third consideration is efficiency and cost-effectiveness. We hear from our clients that software providers will sometimes show them a solution that initially looks good, but when they start to use it is too costly to get the accurate, complete, normalized data that they need. Agility is also vital – the ability to build around the data solution. It cannot be built in isolation. To benefit from data in decision-making, market participants need to think about how they will use it, building solutions that can be incorporated into their corporate identity and asset management processes to make them more efficient. They need to consider the ecosystem that is going to support and live around the data solution.
Finally, it must be usable. Data solutions should be designed to help investors to make decisions when they are considering what to buy or sell, without them needing to be technologically-savvy. Using data better is not a technology problem, it is a decision-making problem. Technology is critical to solving it, but getting the design of that technology right, and building a supporting ecosystem around it, requires a combination of people and technology.
To what extent has the real estate industry embraced the digitization of private markets fund administration?
The good news is the industry sees the need. The market is sold on the idea that we must modernize and move to next generation capabilities to grow the alternative marketplace. Different providers, investors and managers are at different stages of the maturation process. There are not many sophisticated investors and managers out there who believe that the status quo as it was a couple of years ago is sufficient. Some have moved faster than others, and frankly, that’s fine.
What you don’t want to do is jump in with a solution that that you will regret later. We see a lot of that among clients who made technology-related decisions a year or two ago. Being a pioneer or first mover may not always be best, unless you first think through how it will work in practice. The pitfall is failing to understand when you make these decisions, what you are going to get at the other end, and how you are going to maintain and scale it.
What options are open to managers looking to improve their processes for managing data?
One is to work with a trusted back-office provider, especially one that has made a sizable investment and built out capabilities the way Alter Domus has over the past couple of years. Another option is for managers to do it in-house. That is a very challenging task. It is extremely expensive and keeping up with market standards may be difficult. Having said that, a lot of our clients are building modern solutions for their workflow. The two approaches are not mutually exclusive. A manager can have their admin provider be a big part of it, while also making changes themselves. Both need to take the journey at the same time and build solutions together.
A third option is for the manager to piece together various third-party solutions, licensing a variety of tools and applications from various providers and merging them into one integrated solution. That presents two major challenges. Firstly, they have effectively recharacterized the challenge as a technological challenge by hiring software providers that lack critical domain expertise. Therefore, the data they provide may not be as accurate and complete as the manager would desire. They will need their own team in place to make it fit for purpose. Secondly, they will have the extremely difficult job of connecting all the different solutions. Trying to solve those problems with several individual software providers can get extremely expensive.
How has Alter Domus, faced with more clients, more data, and more complex mandates, sought to meet those challenges?
We have made large investments in automating and scaling our capabilities to support our clients through our Accelerate program, which began two years ago. We have greatly enhanced the capabilities of our applications, workflows with our clients, and the delivery of data and analytic solutions to them. We are locked arm-in-arm with a lot of our clients on that journey.
Over that period, we have been doing the foundational work to aggregate data, tag it, build workflows, tools, engines, and analytics, all sitting underneath our storefront Vega platform. That provides a single, centralized platform where clients can access all the tech solutions they currently use and “shop” for others. And within Vega, if clients want an aggregated view of the data across their portfolios, they can access that through our Gateway application. That allows them to drill through all their funds to look at exposures and correlations.
How do you expect digital platforms to evolve in the future? Could artificial intelligence have an impact in this area?
Over the next couple of years, the market will be very busy tackling the challenges of data accuracy, scalability, efficiency, agility and usefulness. And along the way, technology will continue to evolve. At Alter Domus, while the data we are bringing into the Vega storefront is substantial, it is probably not complete.
As they become more successful at managing their data, clients will see the potential to keep growing these platforms, so that they could eventually become the single source of truth, lock stock and barrel, across their organizations. We are already incorporating elements of AI into our solutions, for document classification and document data extraction, for example.
As we get better at this, AI could be used to create widgets and applications that sit within the data ecosystem, providing tailored analytics and reports. However, it is critical to understand that without a clear focus and direction for using AI, organizations could just be spending a lot of time and money on theoretical impractical solutions. Our approach is to look for short term wins that show how AI could be part of the solution.
How can applying digital solutions benefit investors, and administrators working on their behalf?
Investors want to see performance. Employing digital solutions can help them to generate greater returns at a certain level of risk, as well as fine-tuning that risk and better identifying which risk they want to take. That is because they can perform analysis that they were not able to perform before, drilling through to the risk factors: credit risk, property risk, demographic risk.
That capability allows investors to greatly improve the performance of their portfolio. As well as improving performance at the individual asset level, you can also apply analysis across the portfolio in a way that has been difficult to do in private alternative markets up to now. It is very exciting what this opens for investors, and I am very confident we are going to get there as an industry.
