Join us in Philadelphia on April 18^th as we attend LSTA’s Operations Technology Conference: “Transforming the Loan Market Through Operations and Technology”. Our team of Tim Houghton, Julie DeBlois, Janet Roche and Matt Linke will be attending the event to meet and speak with other members of the broadly syndicated loan and private credit markets. From loan market fundamentals to best practices in trade settlement and restructurings, the event is set to cover a broad range of topics and provide solutions to operational challenges in the market. Keen to find out how Alter Domus can help you solve those problems? Get in touch with our team today!

We have seen significant fund closings and even bigger fund launches in the opportunistic credit space. Why is that corner of private debt proving so attractive?

Opportunistic credit, or special situations, is proving popular for a lot of the same reasons that private credit as a whole is attracting the attention of investors. The difference, of course, is that opportunistic credit funds offer a potentially greater uplift, particularly if you are talking about heavily distressed scenarios. Those types of restructuring deals come with significant outsized return expectations when the distressed assets get restructured or repositioned.

We have seen institutional investors increase allocations to private credit consistently in recent years to take advantage of the yield profile offered by those investments, which are now in the high single to low-double digits for performing loans, even stretching into the mid-teens. On a levered basis, you can go even higher. When you consider a special situations or opportunistic credit strategy, you are looking at returns in the 20-30 percent bracket, which is clearly attractive. I think that is the fundamental draw these funds are able to offer to investors anticipating a credit cycle correction.

What are the key macro factors propelling this opportunity set in the current market environment?

The impact of higher interest rates is starting to make itself felt. A lot of businesses, and particularly sponsor-backed businesses, are beginning to feel the pressure of that increased interest rate burden. At the same time, there has clearly been a profound impact on the consumer, in terms of maintenance of household budgets and the ability to consume. That, in turn, is having knock on implications for the companies manufacturing and selling products to consumers, especially if they have meaningful levels of indebtedness.

I think those trends will continue this year. We have not seen the same level of refinancing that we did a few years ago. Deals are not being restructured at the same velocity and that is inevitably going to impact borrowers, with structural defaults and covenant breaches pushing some credits into meaningful restructuring scenarios, which is often a precursor to a broader market trend that might lead more distressed opportunities.

There have been some aggressive predictions made, suggesting that private debt default rates could reach 5 percent this year. What are your thoughts on that and what implications could that have for opportunistic credit?

Yes, Bank of America research produced in October last year estimated that private debt defaults would soon reach 5 percent, thereby exceeding de[1]fault rates for syndicated loans, based on the fact that around one-third of deals in debt fund portfolios were due to mature within 30 months. That default risk is certainly one cloud hanging over the private credit industry right now, while at the same time creating potential opportunities for opportunistic credit managers.

Which loans are particularly at risk and therefore where do you see opportunistic plays emerging?

Private debt, as an industry, is still relatively young. It only really emerged as a fully-fledged asset class in the aftermath of the global financial crisis, when banks were retrenching from new lending to rebuild balance sheets and manage legacy portfolios.

Since that time, the private debt industry has expanded rapidly. In fact, according to PitchBook, it has swelled from $280 billion in assets under management in 2009, to $1.5 trillion in 2022, as managers have seized the opportunity to fill the void left by banks.

During that time, private credit has never really had to tackle a true market downturn and many of these credits now maturing were issued in a bull market, characterized by high levels of leverage and loose terms. Meanwhile, some managers, particularly those looking to build market share, took on more marginal transactions with especially aggressive capital structures. Those are the credits that will be particularly exposed.

In general, I would say that larger and more established platforms will have been less likely to chase the market in 2021 and 2022 and will therefore have more resilient portfolios. Those managers are also more likely to be well resourced when it comes to managing out any credits that do fall into stress. By contrast, newer managers with smaller teams are likely to come under more pressure. Ultimately, this could lead to a bifurcation in the private credit market, with top tier firms attracting an ever-larger share of both dealflow and fundraising.

Are there any particular sectors where opportunistic credit situations are more prevalent, in addition to consumer and retail?

With the exception of consumer and retail, I wouldn’t say that there is any pronounced trend with regard to the industry focus of our clients in this space right now. We are still in the early stages of how this interest rate environment is going to play out, so I think it is too early to tell. However, I would say that there has been a fair amount of portfolio rebalancing in the oil and gas industry. A lot of the traditional lenders in that space – the big retail banks – are starting to rotate out.

How is the opportunistic credit GP landscape evolving? Are we seeing many new entrants?

I think the players that have been active in this market for some time are continuing to raise funds to take advantage of the anticipated market dislocation. But I would say we are also seeing new managers looking to build teams in or[1]der to enter the space. Some of these new entrants are big name asset managers with a strong legacy in private equity. Others have a strong legacy in direct lending. They are not only looking to access these opportunistic credit deals, but also to market new strategies and new funds to their existing investor base.

How do you see the opportunistic credit market evolving?

I think that there will be a lot more borrowers testing the limits of their credit agreements. That is going to lead to forced divestment for the legacy credit funds that are currently holding onto those assets. It will therefore also lead to opportunities for opportunistic credit funds to participate.

There will probably be some initial mispricing of risk with those credits, but over time, and as the volume of dealflow grows, I think the market will establish a cadence and risk will begin to be priced correctly.

Perhaps, the biggest issue that I see on the horizon is the fact that some of these broadly syndicated loans are billions of dollars in size, which is not something that special situations of opportunistic credit funds have come across in a while. They have more typically dealt with mid-market private credit loans of a couple of hundred million dollars. It will be interesting to see how managers choose to participate in those situations and how pairings of certain GPs plays out.

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This article was originally published in PDI’s Opportunistic Credit and Distressed Debt special report.

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John Budyak will be attending the NTAGGL Mid-America Lenders Conference in Fort Worth, Texas. Meet him there from April 2-4 to hear the latest updates in the SBA lending space for both bank and non-bank lenders. John looks forward to meeting with other attendees. Get in touch today!

Join Jamie Loke in Singapore this week at the Private Debt Investor APAC Forum! From 27-28 March, she’ll be attending the event to uncover how private debt can create strong returns and support portfolio growth from a diverse investor standpoint.

Don’t miss the chance to meet her there to discuss our complete range of private debt solutions. Get in touch with her today using the contact details below.

Luxembourg, London and Chicago, March 4^th, 2024 – Alter Domus, a leading global provider of end-to-end tech-enabled fund administration, private debt, and corporate services for the alternative investments industry, today announced that it has secured a new strategic investment from Cinven. Cinven is a leading international private equity firm focused on building world-class global and European companies. The transaction gives Alter Domus an Enterprise Value of €4.9 billion ($5.3 bn).

Through the transaction, Cinven will support the long-term strategic growth of Alter Domus, working in close partnership with the founders of Alter Domus and Permira, who will continue to be significant shareholders. Their continued involvement and investment in the firm is a huge endorsement for Alter Domus as a business, its global growth strategy to date and its future potential. The new structure means Alter Domus will now benefit from the support of three fantastic partners in Cinven, Permira and the founders, and this transaction strengthens the capital base of the company enabling it to focus on the next stage of its growth.

Established in 2003, Alter Domus is one of the largest fund administrators globally, with over $2.5tn assets under administration (AUA). Solely dedicated to alternative assets, Alter Domus offers end-to-end tech-enabled fund administration and corporate services across three sectors: private equity, real assets and private debt. With the support of Permira since 2017, the firm has grown rapidly to meet the evolving needs of its client base, building a global network that now spans 23 jurisdictions, servicing 90% of the top 30 asset managers globally. Since Permira’s investment, Alter Domus has increased revenue, EBITDA and employee numbers by 5x.

Additional investment characteristics of Alter Domus that were attractive to Cinven include:

• Its impressive financial track record, with Alter Domus having consistently outperformed the market, delivering double-digit organic growth and attractive margin performance;
• Alter Domus represents a scarce, market-leading global fund services platform that delivers market-leading service levels to a blue-chip customer base including 90% of top-30 asset managers served;
• It is a proven M&A platform in the fragmented fund services market that has a successful track record of acquisitions, and a strong further pipeline of potential buy and build opportunities across a range of markets and geographies;
• The company operates in attractive markets, with the fund services subsector benefitting from the structural growth of private capital markets, increasing regulation and a continued trend towards outsourcing of fund services, together with downside-protection through strong revenue visibility and cashflow generation;
• Alter Domus has received significant investment in the tech-enablement of the company – resulting in best-of-breed third-party platforms, workflow automation and a leading data and analytics product capability to better serve the increasingly complex needs of its global client base; and
• It has an experienced and highly respected management team that has led the strong performance to date.

In little more than two decades, Alter Domus has grown from being a small Luxembourg-based spin-off from PwC to become a world-leading fund administrator. The investment from Cinven is a significant milestone in the development of Alter Domus as it continues along this trajectory. Together with Permira, we are confident that Cinven is the perfect partner as it continues to grow and scale internationally, and I am excited to continue to be a part of the Alter Domus journey.

Alter Domus Founder and Chairman of the Supervisory Board, Rene Beltjens

With an enviable track record of investing in fast-growing, world-class businesses, we are thrilled to welcome Cinven as an investor in Alter Domus. Cinven shares our strategic vision and commitment to developing long-term technology-enabled partnerships with the leading alternatives firms globally through the delivery of operational and client service excellence. Together we look forward to further accelerating our international growth and delivering innovative new services to our clients.

Alter Domus Chief Executive Officer, Doug Hart

Cinven is delighted to make this investment in Alter Domus. Fund services has been a priority subsector for Cinven’s Business Services team due to the attractive business model characteristics and strong growth drivers. Cinven’s Business Services and Financial Services sector teams have worked together in close partnership and have followed Alter Domus closely over many years and admired it as a global leader, with blue-chip clients and leading service levels. Looking forward, we see significant potential for further growth and we look forward to working with the management team and shareholders in the next phase of its journey.

Cinven Partner and Head of the Business Services sector team, Rory Neeson

We would like to thank René Beltjens, Doug Hart and the entire Alter Domus team for their hard work and passion that has allowed our partnership so far to be so successful. The company is now well positioned as a global leader to enter its next phase of growth with the support of an aligned set of shareholders, and we’re looking forward to working closely with Cinven, the founders and management to continue capitalising on the growth opportunity ahead.

Global Head of Services at Permira, Philip Muelder, and Chris Pell, Principal at Permira

The transaction is subject to regulatory approvals and other customary closing conditions.

Alter Domus was advised by Goldman Sachs International and Raymond James (M&A), DLA Piper, Jamieson Group (Dedicated advisors to management), Oliver Wyman (Commercial), EY (Financial & Tax) and Clifford Chance (Legal), Kroll (Compliance), Crosslake (Technology).

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About Alter Domus

Alter Domus is a leading provider of tech-enabled fund administration, private debt, and corporate services for the alternative investment industry with more than 5,100 employees across 39 offices globally. Solely dedicated to alternatives, Alter Domus offers fund administration, alternative investment services, corporate services, depositary services, capital administration, transfer pricing, domiciliation, management company services, loan administration, agency services, trade settlement and CLO manager services.

Find out more at www.alterDomus.com.

About Cinven

Cinven is a leading international private equity firm focused on building world-class global and European companies. Its funds invest in six key sectors: Business Services, Consumer, Financial Services, Healthcare, Industrials and Technology, Media and Telecommunications (TMT). Cinven has offices in London, New York, Frankfurt, Paris, Milan, Madrid, Guernsey and Luxembourg.

Cinven takes a responsible approach towards its portfolio companies, their employees, suppliers, local communities, the environment and society.

Cinven Limited is authorised and regulated by the Financial Conduct Authority.

In this press release ‘Cinven’ means, depending on the context, any of or collectively, Cinven Holdings Guernsey Limited, Cinven Partnership LLP, and their respective Associates (as defined in the Companies Act 2006) and/or funds managed or advised by any of the foregoing.

For additional information on Cinven please visit www.cinven.com and www.linkedin.com/company/cinven/.

About Permira

Permira is a global investment firm that backs successful businesses with growth ambitions. Founded in 1985, the firm advises funds with total committed capital of approximately €80bn and makes long-term majority and minority investments across two core asset classes, private equity and credit.

Permira is one of the world’s most active investors in the Services sector, having deployed over $11.5 billion to partner with more than 40 companies globally. Current and previous investments from the Permira funds in the sector include: Acuity Knowledge Partners, Axiom, Cielo, Clearwater Analytics, DiversiTech, Engel & Völkers, Evelyn Partners, Kroll, Motus, Relativity, Reorg and Tricor.

The Permira private equity funds have made approximately 300 private equity investments in four key sectors: Technology, Consumer, Healthcare and Services. Permira employs over 500 people in 15 offices across Europe, the United States and Asia. For more information, visit www.permira.com or follow us on LinkedIn.

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Media Contact: [email protected]

Katherine-Hope Keown: +44(0)7512 309360

Read Cinven‘s press release here.

Read Permira‘s press release here.

In the dynamic world of alternative investments, Broadly Syndicated Loans (‘BSL’) continue to be an important part of the market. The Leveraged Loans market as a whole yielded a near record 12% return this year. And CLOs are expected to continue to have high issuance in 2024, with most banks forecasting between 100 and 115 billion in new issuance this year, numbers quite similar to last year’s high level of issuance.

Amidst today’s high interest rates, it’s no surprise that the BSL market has become and continues to be a popular choice for investors seeking attractive yields and a relatively low risk profile. We’ve previously written about BSL characteristics, loss protecting features, and prepayments. We now additionally consider macroeconomic factors that drive prepayments. 

As the market grows in importance, investors are increasingly asking how BSLs might perform under a range of macroeconomic conditions. While some discussion has gone into monitoring default risk via stress tests, most stress testing is primarily focused on default risk and instead opts to zero out prepayments as a conservative assumption.

While this creates simplicity, it runs the risk of creating excessively conservative and unrealistic stress tests. This simplicity ignores an important fundamental concept in credit risk – the Exposure At Default (‘EAD’). EAD is a critical component of credit risk – in addition to probability of default (‘PD’) and loss-given-default (‘LGD’).

Using our Risk Modeler Analytics platform, we can adopt a more prudent approach to stress testing that considers both default risks and prepayment risks and ensures that EAD is addressed. Prepayment analysis is also generally critical for BSL investors for proper cash management, including investor redemptions and reinvestment strategies.

In our previous article, we discussed the benefits of forecasting prepayments and looked at a broad set of factors that can predict prepayment rates. However, we did not consider macroeconomic factors, which raises the question: Why might someone want to focus heavily on macroeconomic factors when forecasting prepayments?

Firstly, aggregate prepayments vary wildly across time, ranging from 3% to 12% on a quarterly basis in our sample portfolio. Secondly, these prepayments correlate strongly with macroeconomic factors in ways that are consistent with sound economic reasoning, suggesting that the correlations will hold in future scenarios.

Finally, this opens up the door to incorporating scenario-based thinking and stress testing as a means of driving analysis and decision-making. An important note to consider is that scenario analysis need not necessarily be only regarding stress scenarios.

Given the novel combination of interest rates and inflation in the current macroeconomic environment, numerous different positive scenarios can be constructed with different implications for prepayments. Considering such scenarios is increasingly important for sophisticated BSL managers attempting to do cash flow management.

Modeling approach

As part of our process, we selected a sample of loans from our BSL universe and attempted to model prepayments primarily using macroeconomic factors. We used two broad approaches to create our models, incorporating insights commonly observed in loan agency practices to better understand borrower behavior and repayment trends.

The first approach, called the holistic approach, focuses on a wide range of macroeconomic factors. This approach allows users to potentially consider scenarios based on variations of any of these variables. For example, one might consider a high inflation/low-interest rate scenario, a high GDP/high inflation scenario, or any other combination. 

The second approach, called the targeted approach, focuses on a single specific variable along with its lags. This has the advantage of creating a parsimonious model, which is easier to understand and implement.

Holistic Model

The holistic model attempts to capture the macroeconomic factors that could affect loan prepayment speed. Inflationary pressure, macroeconomic outlook, and the interest rate environment are some of the macroeconomic factors that are generally expected to be relevant to BSL prepayments.

With this idea in mind, we assembled a large set of macroeconomic factors and tested them in combination with each other. Instead of testing all combinations of all transformations of the relevant variable pool, we tested combinations of the most important variables and avoided trying too many different transformations and combinations. The result is a model that includes several variables that are intuitive and logical.

The following variables are included in the model, along with an explanation of the economic reasoning for having them:

• CPI (quarterly growth) –This variable captures the current quarter’s inflation rate. As such, it tells us about the current inflationary environment and provides a decent proxy for inflation expectations moving forward. Borrowers facing higher inflation expectations will be more inclined to find alternatives to prepayment (i.e. reinvesting in the business) and thus prepayments would be expected to decrease, all else equal.
• S&P 500 (year-over-year growth) – As public equities markets are forward looking indicators of macroeconomic growth, the change in S&P valuations gives us a good indicator of how markets feel about macroeconomic prospects. When the S&P is improving, prepayments increase reflecting the fact that borrowers likely feel enough optimism to attempt to pay off more of their debts and/or raise equity financing to prepay debt.
• High Yield Index Option-Adjusted Spread – The spread considered looks at yields of corporates with ratings of BB or less with respect to a spot Treasury curve. The index has a negative relationship with prepayments, all else equal. When spreads decrease, borrowers are less inclined to hold loans still tied to a higher spread from a previous high spread period. As such, they’re likely to prepay knowing that they have the option to get new financing under a more favorable spread.

In Exhibit 1 below, we see the model fit through historic data. In the earlier parts of the data, the sample of loans is not yet fully populated and consequently a bit more volatile from period to period. As such, the fit isn’t as strong. But from 2018 forwards, the model-fit is quite good and we can see that the model captures the major swings in prepayments that have occurred in response to the significant macroeconomic shifts that have occurred since 2018.

Exhibit 1: Macro Model Fit

Targeted Model

While the holistic model captures a good deal of nuance regarding the various factors that could drive prepayment risk, the complexity creates some costs. Coefficients become harder to interpret as more variables enter the model.

Creating logically consistent alternative scenarios becomes harder as more variables must remain consistent with each other. As an alternative one could consider a simpler model that focuses on just one variable along with its lags. Fortunately, when one looks at the High Yield Option-Adjusted Spread, one finds such a variable.

Simply plotting the two variables against each shows a strong inverse relationship between spreads and prepayments. There’s also a straightforward and logical explanation. When spreads are lower, borrowers prefer to prepay and take advantage of lower spreads for refinancing. When spreads are higher, borrowers do not.

Exhibit 2: Spread vs Prepayment Rate

We can also consider lagged values of yield data, which points to an inverse relationship between spreads and prepayments. Lagged values are positively correlated with present prepayments. This can be explained by seeing current and previous spreads as both playing a role in driving prepayments.

If today’s spreads are low, but 6 months ago spreads were also low, then prepayments might not be as high as in an alternative situation where today’s spreads are low but 6 months ago spreads were extremely high. In the first case, borrowers likely took advantage of low spreads, but in the latter case, borrowers likely have high spread loans that they would be eager to refinance.

Exhibit 3: Target Model Fit

Scenario Analysis

Creating forecasts across scenarios is necessary for doing scenario analysis. To do so, we start with a simple baseline forecast for High Yield Spreads, that shows it steadily decreasing over the near term. For alternative scenarios, we simply take the forecast and bump them up and down by 2 standard deviations of the series’ historic values. With that straightforward scenario prepared, we can create prepayment forecasts for our portfolio to see the impacts of changing spreads.

We can see the results below in Exhibit 4. Higher spreads lead to lower prepayments, lower spreads lead to an increase in prepayments. Interestingly, because we use previous values of spreads in the model, the model inherently recovers towards the baseline. This makes sense intuitively. If spreads drop, borrowers would prepay and refinance to take advantage of new lower spreads.

But if spreads remain at that level, borrowers will eventually no longer need to keep refinancing. By the converse, when spreads rise that may initially create difficulty for prepaying, but as borrowers adjust to the higher spread environment, they may find themselves reverting to their more typical prepayment behavior.

Exhibit 4: Scenario Forecast

Out-of-sample Results

These models were developed in early 2023 with data only being available through 2022Q4. At the time of writing, both prepayment and macroeconomic data were available through 2023Q3, allowing us to evaluate the accuracy of our forecasts by comparing them to the actual data.

The results showed a notable divergence between forecasts and actuals for both models with the actual data remaining at very low levels while the forecasts increased. In the holistic model, the lowered spreads, reduced inflation rate, and S&P 500 gains all drive predictions upwards.

In the targeted model, we witnessed spreads increase in 2022, followed by a decrease in 2023. According to the model, that combination will lead to increasing prepayment rates.

To explain this divergence, we can consider the possibility that pessimistic expectations about the future state of the macroeconomy led borrowers to avoid prepayment. The series of bank failures in March 2023 led to serious concerns of a potential wider banking and economic crisis.

Beyond that, the continued interest rate hikes led to widespread concerns that the effort to beat back inflation might cause a recession. The volatile geopolitical environment further exacerbated these effects to increase market volatility and stress market sentiment. With these different perceived risks to the macroeconomy, borrowers would likely hesitate about prepaying even if the current macroeconomic data showed signs of improvement. 

We can see evidence of forward-looking pessimism in a number of data sources. According to NABE, a majority of Economists surveyed in February 2023, expected a recession in the next 12 months. Furthermore, consumers showed similar pessimism regarding the future.

Within the Consumer Confidence Index, the Present Situation Index and Expectations Index diverged in recent data. The Present Situation Index recovered substantially in 2021 and has remained at a high level. Whereas expectations began dropping in 2022 and have recovered only slightly since then.  However, to fully understand the impact of these perceptions on prepayment behavior, it’s important to examine business perceptions as well. After all, businesses are the actual borrowers in this context. 

The OECD’s Business Confidence Index shows a similar pattern. Business Confidence peaks in early 2022 as it recovers from the COVID pandemic, but then begins declining from there. In early 2023, it bottoms out close to its pre-COVID level and remains at that low level.

Another frequently discussed forward looking indicator for recessions is the 10-year 2-year Treasury Spread. The indicator has predicted every recession between 1955 and 2018. The yield curve has been negative since July 2022, suggesting that markets are expecting a downturn in the new future.

Having considered an explanation for the forecast divergence, one can consider modifying the model to improve its performance going forward. Given the popularity of the 10-year 2-year Treasury spread as an indicator of recessions, we can consider using that in the model.

We take the holistic model consisting of S&P 500 growth, High Yield Spreads, and CPI growth. Both the S&P 500 growth rate and the 10-year 2-year spread are capturing future expectations of performance. So, we can try substituting the S&P 500 growth rate with the 10-year 2-year Treasury Spread.

When we evaluate the new model, we find that it does better in back-testing exercise for 2023 (as see in Exhibit 5), as well as in a rolling back-test exercise where we consider each of the previous years as potential holdout samples. Given that, the revised model seems to do better forecasting both history and recent data, we can consider using it as a champion model going forward.

Exhibit 5: Out-of-sample results for Revised Model

Conclusion

In this article, we have explored how macroeconomic factors drive prepayment risk in the BSL market and the importance of stress testing and scenario analysis in making informed investment decisions. Through our Risk Modeler Analytics platform, we presented two approaches for thinking about macroeconomic factors: 1) a more sophisticated approach that considers numerous macroeconomic factors and 2) a more straightforward approach that is easier to implement for scenario analysis.

We then reviewed the out-of-sample results and recent macroeconomic data. We found that incorporating 10-year 2-year Treasury Spreads as a factor in the model could improve the model’s out-of-sample forecasting results and have added that into a new model moving forward.

In conclusion, understanding how macroeconomic factors affect prepayment risk is crucial in evaluating BSL investments. By utilizing scenario analysis and macro-based models, investors can gain insights into borrower behavior and make informed decisions that drive analysis and decision-making to allow BSL managers to manage their portfolios and optimize their returns.

Fortunately, a holistic model that incorporates inflation, 10-2 Treasury Yield Spread, and high yield spread variables offers a powerful, intuitive, and effective model input to facilitate this important prepayment analysis. These insights can also inform loan services that support modeling and monitoring needs. Stay tuned for the next prepayment analysis of loans issued by public capital market participants and retail lenders.

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Alter Domus is delighted to be sponsoring the Carolinas Credit Union League’s Launch Conference from February 7^th-8^th. Professionals from across the credit union space are set to gather in Concord, North Carolina for the two-day conference, featuring breakout sessions, workshops and more.

At the conference, Alter Domus’ very own Harvey Plante and Brian Hanson will be sharing their insights on the “CECL Reporting & Tech’s Role in Credit Risk Management” panel on February 7^th at 2:40pm. They’ll cover the evolution of CECL and the role it plays in the credit risk management framework and will provide best practices and tips for success in strengthening your CECL processes and preparing for audits and stress testing using industry analytics.

Stop by Booth 310 to meet Harvey, Brian, and the rest of the team including Jeff Sykes and Eric Tannenbaum. They look forward to meeting you there!

Anticipation is high in the alternative assets space. But to understand why fund managers are so engaged with ELTIF 2.0 – which came into effect on January 10 2024 – you must first appreciate why the original ELTIF framework did not live up to expectations.

In the eight years that it was in place, the original ELTIF regime managed to raise fewer than 100 funds with total assets under management estimated at approximately €7 billion. Tellingly, most European Union member states did not establish any. In our view – and this is an opinion which appears to be almost universal across the industry – the take up was slow because the original ELTIF was, in some instances, too restrictive. This was particularly true in relation to eligible investments which required a minimum €10 million value threshold, and the ability to invest other funds was limited to other ELTIFs. Additionally, there were limitations to marketing rules for retail investors, all of which contributed to ELTIF 1.0 not being widely adopted.

Fortunately, Article 37 of ELTIF 1.0 mandated that the European Economic and Monetary Affairs Committee (ECON) had to start a review of the application of the regulation no later than June 9 2019. From this review, ELTIF 2.0 was born. In its November 2021 report to the European Parliament and Council, the Committee noted the key problems with the framework –on both the demand and supply sides.

So what has changed?

Demand side

On the demand side, with the ‘democratization’ of alternative assets, the enhanced regulatory regime promises to support managers in addressing the retail market, and to broaden investment opportunities. Under ELTIF 2.0, the entry barriers for individual investors have been removed, including the minimum investment threshold of €10,000 and net-worth requirements. 

One of the main components of ELTIF 2.0 – which we discussed in the opening article of this series looking at pre-marketing – is the ability to use the European marketing passport to distribute an ELTIF 2.0 product. This greatly simplifies the distribution setup and removes the retail barriers of ELTIF 1.0, although a suitability assessment, as required under MIFID II, still applies to retail investors.

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Supply side

On the supply, or product, side the changes in ELTIF 2.0 aim to remove the restrictions that hindered the success of ELTIF 1.0. The key changes as outlined in the table below, coupled with the relaxation in redemption limitations provide for the desired flexibility that was absent in the original regime.

Supply Side Changes

	ELTIF 1.0	ELTIF 2.0
Threshold for Eligible Assets	70%	55%
Maximum concentration limit	10%	20%
Borrowing limit (retail)	30%	50%
Max market cap of equity or debt issuers	EUR 500m	EUR 1.5bn
Minimum Investments in real Assets	EUR 10m	EUR 1.0m
Ability to invest in AIFs (Fund of Funds)	No	Yes
Ability to invest in underlying securitizations	No	Yes
Investment in non-EU assets	No	Yes

Ready for the new regulatory framework 

Even before launch, interest in ELTIF 2.0 was gathering momentum. As we mentioned in the second article of this series, some of the biggest players in the market, from Blackstone to KKR to Apollo, were already engaging with this new framework, looking to make the most of the regulations. But what should fund managers who are looking to raise capital in Europe be thinking about?

In the fourth and final article in this series, we will be taking a closer look at the expected impact of ELTIF 2.0 as well as the challenges and considerations for managers and service providers. Now that ELTIF 2.0 is live, what should you be considering, what are the challenges and how might you manage them?

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Learn more about Alter Domus’ AIFM Services and Private Equity Solutions.

What to watch out for 2024:

• Securing exits will be the number one priority for GPs in 2024, as they strive to return cash to LPs and get fundraising moving again
• GPs will explore all routes available to them to realise liquidity, including alternative GP-led secondaries and using NAV loans to make distributions
• LPs will use secondaries markets extensively too, exiting existing holdings to free up cash and make commitments to the new funds of top tier managers
• The peak of the interest rate cycle should reignite M&A and IPO markets, helping to clear the backlog of unexited assets sitting in GP portfolios

The private equity industry goes into 2024 coming off the most challenging period for the asset class in more than a decade.

The combination of rising interest rates, higher acquisition finance costs and geopolitical dislocation have had a chilling effect on year-on-year buyout, exit and fundraising activity.

According to law firm White & Case, global buyout deal value has almost halved in 2023, falling to $442.2 billion over the first nine months of the year from $864.96 billion over the same period in 2022. The drop in year-on-on-year exit value has been similarly precipitous, contracting 51% to $240.75 billion over the same period.

Jammed up deal markets have had a direct impact on fundraising. As exits have dried up, managers have been unable to realize value and return cash to investors. According to Burgiss data quoted by Bloomberg, private equity limited partner (LP) cash flows have turned deeply negative, with the gap between capital calls and distributions widening to levels greater than the observed in the depths of the 2008 global financial crisis.

The lack of liquidity has left LPs with limited headroom to make allocations to the next vintage of funds, with private equity fundraising cooling to its slowest rate in years, according to Pitchbook figures cited by Bloomberg.

The exit imperative: liquidity the priority for 2024

Looking ahead to 2024, the number one priority for the general partner (GP) community will be unblocking the fundraising bottleneck by getting cash back into the hands of investors, and the best way to do that will be to fire up exit deal value again.

According to Bain & Co analysis, buyout funds alone are sitting on an all-time high $2.8 trillion of unexited assets in their portfolios – more than four times higher than the thresholds recorded during the global financial crisis. Finding buyers for these assets and returning cash to LPs will alleviate the pressure on investor cash flows and get fundraising moving again.

Of course, the challenge for GP vendors during the last 18 months has been to find buyers willing to meet valuation expectations for assets. As interest rates have climbed, establishing consensus on pricing has become increasingly difficult. No GP has wanted to offload a good asset at bargain valuation at the bottom of the cycle, while buyers have found it very difficult to structure deals when there is limited visibility on future earnings and financing costs. The result has been M&A stalemate.

Creativity required

GPs will be exploring all options available to them for realizing liquidity and returning cash to investors in 2024 if conventional exit routes (strategic sales, secondary buyouts and IPOs) remain becalmed.

The market has already observed and tested what some of the options could be. More GPs are now exploring GP-led secondaries deals when planning exit routes, and are expected to continue doing so in numbers in the year ahead.

These structures, which see selected assets placed into continuation funds, give LPs the option to take liquidity or rollover their stakes in the asset into the continuation fund. For GPs with good assets, but under growing pressure to make distributions to investors, a continuation fund can provide tidy solution that allows for LPs to receive cash without managers having to sell off prized portfolio companies at bargain prices in bear market.

According to Jefferies, these GP-led deals account for 42 percent of overall secondaries deal value in H1 2023, which although down on the share observed in. the bull market of 2021, is significantly higher than pre-pandemic levels. 

LP-led deals (where investors sell their stakes in funds to secondaries funds) will also be a key dynamic in the asset class in 2024. LPs have increasingly taken direct control of their cashflows by using secondaries deals to expedite routes to liquidity. LP-lead deals accounted for less than half of total secondaries deal value in 2021, but share has climbed to 58% in 2023, according to Jefferies. 

Secondaries sales will remain an important tool for investors in 2024, especially when elite managers come to market with new vintages. LPs who don’t have immediate access to liquidity to allocate to these blue-ribband GPs will turn to the secondaries market to exit existing holdings in order to make commitments to their preferred firms.

Another route to liquidity GPs are exploring are NAV loans, where managers take out debt secured against the assets in fund and use the proceeds to make distributions. These arrangements are still relatively novel (and not without controversy, as distributions can be recalled if GPs can’t repay the NAV debt), but some high-profile private equity brands have put NAV loans in place to make distributions and others may follow suit.

Traditional exit routes: reason for optimism

There is growing, but still cautious, optimism that conventional exit routes will also start to unfreeze in 2024.

The outlook for interest is underpinning this sanguinity. After enduring the steepest pace of rate hikes in more than four decades central banks around the world do appear to have hit peak rates.

GPs would prefer rates to be lower than they are, but even if rates do stay at current elevated levels, there is at least some clarity in the market on what interest rate assumptions to build into deal models. This will go a long way to recalibrating buyer and seller pricing expectations, narrow the bid-ask spread on valuations and hopefully get deal markets flowing again.

There are already early signs that a more stable outlook is opening up traditional IPO and M&A markets. In 2023, buyout firm GTCR went ahead with the largest deal in its history with the $18.5 billion carve-out of payments company Worldpay from Fidelity National Information Services, in transaction that enjoyed strong support from debt markets.

After challenging year, GPs will be hoping that more landmark transactions will come to market in 2024.

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What to watch out for in 2024:

• Private debt is ideally positioned for a golden vintage in 2024 as high interest rates drive up yields and capital structures become more conservative
• LP appetite for private debt exposure will remain strong as investors seek exposure to the asset class’s strong underlying fundamentals
• Distinctions between bank and debt fund capital will blur as investment banks and Private Credit Managers build out their direct lending offerings
• The resilience of portfolios will become a key differentiator in a market that will bifurcate

There haven’t been many asset classes that have benefitted from the current cycle of interest rate hikes. Private debt is one of them.

Despite volatile stock markets, a sharp contraction in M&A deal flow and stultified leveraged loan and high yield bond markets, private debt managers have continued to secure investor capital and find opportunities to deploy capital in a tough environment.

According to Pitchbook private debt delivered double-digit year-on-year fundraising growth in 2023, putting the market on track to deliver annual fundraising in excess of $200 billion for the fourth year in a row.

Steady distributions and attractive yields draw investors

The strong performance of the asset class in 2023 has positioned private debt to potentially deliver one of its best vintages ever in 2024.

As base rates are now sitting in the region of five percent, private debt managers can realistically expect to produce yields in the 10 percent to 12 percent range, according to analysis from Barings. The gap to equity returns is not very wide, and with private debt consistently delivering high, double-digit distribution rates, the risk-reward dynamics presented by the asset class w2ill be among the most compelling for investors in 2024.

Private debt managers will also continue to benefit from supply-demand dislocation in wider lending markets. Syndicated loan and high yield markets have been stung by higher interest rates and all but shuttered, with banks reluctant to take on syndication risk at such an unpredictable period in the credit cycle.

According to White & Case figures, leveraged loan and high yield bond issuance across North America and Western and Southern Europe over the first nine months of 2023 declined by almost a fifth year-on-year from $1.13 trillion in 2022 to $920.54 billion this year.

Tightening loan and bond markets and cautious banks have allowed private debt managers to cherry pick deals and issue debt not only at higher interest rates, but also with lower leverage and lender-friendly capital structures.

Reshaping an asset class

The strength of the $1.5 trillion private credit space will drive ongoing and significant evolution of the asset class, with 2024 shaping to be a groundbreaking year.

In the second half of 2023 a growing cohort of banks made strategic moves into private debt, either as cornerstone investors in private lending firms, as seen in Rabobank’s investment in sustainable private lender Colesco; through partnering with private markets platforms, as seen with Societe Generale planning to raise a €10 billion credit fund with Brookfield; or launching dedicated private credit managers inhouse, as Deutsche Bank has done.

More banks, nervous about losing lucrative streams of leveraged loan and high yield fee income to competition from private debt, are expected to make similar strategic moves and step into private credit in some shape or form in 2024. This will blur the lines between the two types of providers and reconfigure the way borrowers look at their financing options in the future.

Default risk looms

The one cloud that will hang over private debt in 2024, however, will be looming default risk.

Private debt as an asset class only really came onto the radar as a credible alternative to conventional bank-led lending after the 2008 financial crisis, when banks retrenched from the market to rebuild balance sheets and manage legacy portfolios.

Since then, private debt assets under management have expanded at pace, as managers seized the opportunity to fill the gap in the market left by the banks. The asset class, however, has never been truly tested through a downcycle and borrowers and investors will be watching closely to see how managers behave when portfolios do become stressed.

Bank of America estimates that the private debt default rate could reach 5% by early 2024, exceeding default rates for syndicated loans. From 2024 onwards, roughly a third of deals in debt fund portfolios will be maturing within 30 months, according to Bloomberg.

Many of these maturing credits would have been issued in bull credit markets and characterized by high levels of leverage and loose terms. Some managers, who were eager to gain market share and took on more marginal transactions with aggressive capital structures, will be particularly exposed.

Bigger platforms didn’t have to chase the market in 2021 and 2022 and are likely to have more resilient portfolios, as well as the resource to manage out any credits that may fall into stress. Newer managers with smaller teams will come under much more pressure if portfolios do become stressed.

This is likely to drive a bifurcation of the market in 2024, as top tier private debt funds take up a growing share of private debt deal flow and fundraising, while smaller firms find that their teams stretched as they try to shepherd current portfolios through distress at the same time as trying to originate new deals.

Evidence of this bifurcation has already started to emerge, with Pitchbook reporting that the number of funds new private debt funds closing has contracted by more than 25 percent, even though year-on-year private debt fundraising value has climbed. This signals that LPs have already begun to focus on relationships with fewer, bigger private debt funds, which are becoming increasingly dominant forces in the market.

Great opportunity lies ahead for private debt managers in 2024 – but there may be fewer managers around to take advantage of it.

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What to watch out for in 2024:

• Interest rate stability will help revive real asset fundraising and deal activity after a difficult 2023
• Bid-ask spreads on real assets should level off although the market will bifurcate according to asset quality and subsector
• Fundraising will pivot decisively to established managers with larger platforms
• Energy transition will be a key driver of long-term real assets growth

Real assets managers will be hoping that cooling inflation and interest rate stability improve conditions for fundraising and investment in 2024 after a difficult 12 months.

Real assets have felt the full force of geopolitical and macro-economic volatility. According to PERE, real estate fundraising contracted to $92.8 billion during the first nine months of 2023, a 38 percent decline on the $150.4 billion secured over the same period last year. The current run rate could see real estate fundraising come in at the lowest annual level observed since 2012. Infrastructure fundraising has slowed significantly too, with CBRE analysis of Infralogic data showing a decline to the lowest levels in more than a decade.

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Hopes for stability

The headwinds that real assets investors have faced through the course of 2023 will persist into 2024.

In the real estate space higher capital costs and conservative underwriting will a remain a feature of the market according to JLL analysis, as companies reassess post-pandemic office requirements; logistics operators reconfigure warehouse portfolios amidst pressures on consumer spending; and investors take longer to make decisions when deploying capital.

In infrastructure, meanwhile, leveraged plays in sub-sectors such as telecoms towers and utilities will remain challenging. According to State Street, rising interest rates have made investments in competing, higher income asset classes more attractive than infrastructure plays, while climbing energy costs and falling global exports weigh on bottom line profitability. According to CBRE these dynamics have seen investors demur from committing to long-term, capital-intensive projects at a high point in the interest rate cycle.

There is nevertheless a degree of cautious optimism that the market backdrop for real assets investment strategies will improve in 2024, albeit below the levels achieved in the bull market of 2021 and early 2022. Interest rates will be the key barometer for a recovery in activity, with JLL expecting a steadier market to emerge should inflation continue its downward trajectory and interest rates stabilize. This could help to bring buyer and seller pricing expectations closer together following a period of volatile pricing shifts and limited deal flow on which to establish consensus on valuations.

Big platforms to dominate

As demand for alternative asset services grow alongside developments in other alternative asset classes, investors will commit the capital they do have available to bigger managers with large investment platforms in an effort to mitigate downside risk in a still choppy deal market. This shift is increasingly being observed among alternative asset managers responding to investor preferences for scale and stability.

Blackstone, for example, has raised at least €4 billion towards its seventh flagship European real estate fund since launching in April 2023, securing more than $3 billion of commitments in Q3 2023 alone. Copenhagen Infrastructure Partners (CIP), meanwhile, has raised €5.6 billion towards the €12 billion targeted for its fifth flagship, while Artemis Real Estate Partners closed its Artemis Fund IV on $2.2 billion, beating its $1.5 billion target.

Large real assets managers have also had the scale and resources to ramp up new strategies where they see opportunity and secure investor support. Real estate debt is one area that has seen a significant uptick in activity. Bain Capital and TPG are among the firms to launch new dedicated real estate debt strategies, while PIMCO closed its sophomore Commercial Real Estate Debt Fund on $3 billion to beat its $1 billion target.

Prolonged fundraising and reduced capital inflows in a slow exit market will also see managers across the board rethink their own operational models and running costs. Outsourcing back-office and middle office infrastructure will move firmly into the frame as firms prioritize reducing staff costs and other overheads.

Energy transition to drive long-term growth

One subsector that will animate real assets fundraising and deal activity for managers of all size is energy transition.

Delivering net zero emissions will require substantial investment, with McKinsey forecasting that $9.2 trillion of annual capital spending will be required between 2021 and 2050 to meet decarbonization targets.

Government and corporate commitments to securing the required investment to meet net zero target have insulated renewable energy and decarbonization projects from market volatility, with capital continuing to flow into these areas despite dislocation in other segments of the real assets space. The US Inflation Reduction Act and Europe’s Green Deal and REPowerEU initiative are among the global initiatives that have encouraged private sector investment into decarbonization.

For real assets managers these dynamics has driven substantial investor appetite for decarbonization and renewables investment strategies.

According to the Long-term Infrastructure Investors Association (LTIA), funds dedicated or partly dedicated to renewable energy have accounted for more than 90% of overall infrastructure fundraising since 2019. This secular pivot towards strategies with an energy transition theme has fed a swelling pipeline of renewable energy deal opportunities, with CBRE analysis of Infralogic data putting global live deal pipelines for renewables at around $3.6 trillion.

Real assets deal activity and valuations wills also become increasingly shaped by broader environmental, social and governance (ESG) concerns that extend beyond energy transition in wider areas of sustainability and energy and water conservation.

In infrastructure and real estate ESG has shifted from a “nice to have” to an essential part of a license to operate. Through the course of 2024 we expect ESG to become an important element of asset valuations, with widening valuation gaps between assets where ESG is embedded into operations and assets where ESG hasn’t been prioritized.

As market conditions improve through 2024 other areas of the market will rally, but energy transition and ESG will remain a key long-term driver for real assets fundraising and deal activity.

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