Regulators have increased their focus on liquidity risk in debt funds. Austin Brady of Waystone explains that this prompted Waystone to increase its loans expertise in order to help clients successfully launch loan funds in Ireland or Luxembourg.
Q: Where in your view does the tighter focus on liquidity by financial regulators in Europe stem from?
A: The aftermath of the Global Financial Crisis saw the rapid growth of credit funds in the leveraged loan market. In Western Europe it has grown from €150 billion in 2016 to over €300 billion in 2020. The figure stands at $1.5 trillion for the US and covers a multitude of sectors.
The growth of credit funds is due to increased regulation imposed on the banking sector in the aftermath of the financial crisis. Combined with the reduced capacity of banks to lend, this has resulted in loan origination funds becoming a more popular source of funding for companies and means the continual growth of leveraged loans is expected. The Alternative Investment Management Association forecasts that up to 20% of SME lending will emanate from loan origination funds by 2022.
Q: How has this vacuum of lending been filled?
A: Accentuated by growing investor hunt-for-yield in fixed income space and the low interest rate environment, hedge fund investment managers have clearly carved out a niche in sourcing and originating private debt and generating returns far superior to bond markets. By focusing on solid companies that are marginally out of the realms for investment bank financing, hedge funds have been able to invest in such companies through loan originations, while generating a pick-up of up to 400 basis points relative to the corporate bond market. Loan originators have also been able to draft robust documentation – particularly during times of distress.
Q: How has the loan origination market performed in the past year or so?
A: The past six months have seen most asset classes improve dramatically as the global economy begins to re-open with the vaccine rollout gathering momentum. In the months preceding the global shutdown, borrowers were faced with additional borrowing costs to the tune of +500bps for 3-year loans. This has now snapped tighter to around +100bps as the lending market has normalised and the market has returned to being more borrower-friendly in terms of the covenants and loan terms.
In terms of defaults, the total percentage of defaults stands at 3% in Europe, well below the estimates from rating agencies (10% default rate is forecast). In CLO space, new issuance for Q1 2021 has already returned to normal and reached new record highs, rating agency upgrades have also increased dramatically – with both factors positively impacting primary and secondary loan markets.
Q: Where does Ireland’s LQIAIF fit into this?
A: In Ireland, the LQIAIF – or Loan Originating Qualifying Investor Alternative Investment Fund - are structures containing loans that are originated by funds to a wide range of borrowers in a variety of countries. The fund is established in Ireland and offers a passport to market the product across the European Union. The loans comprising L-QIAIFs are originated debt, deploying investor capital (or using credit facilities) directly to the end buyer.
Within a syndicated loan transaction, where debt is not originated using investors’ capital, assets are sourced and traded in the secondary market. As other investors hold the same loan, there is additional liquidity in this market. However, while some deals have sponsors, loan origination generally involves a bespoke bilateral agreement between the borrower (company) and the lender (through the fund). While the syndicated loans and originated loan still trade over-the-couter using legal documentation, their syndicated market is a more liquid market in which to trade these loans.
Q: Ireland’s regulator, in common with others, has placed more emphasis on liquidity in loan instruments since the outbreak of the pandemic. How does this affect the LQIAIF?
A: In the wake of the Covid-19 pandemic, much emphasis has been placed on the underlying loans in LQIAIF fund structures in Ireland. As the global economy ground to a halt last year, underlying borrowers struggled to meet principal and interest obligations and thus were in breach of specific covenants embedded in loan documentation. The Central Bank of Ireland (CBI), as Regulator of such fund structures in Ireland, has therefore required more in-depth analysis at loan-level to circumvent such issues occurring in the future.
The additional liquidity burden placed on loan-origination deals is therefore accentuated as the loans are pooled together and the liquidity issues within the fund become more concentrated. In addition, the credit risk within the LQIAIF funds could be impacted as we emerge from the current low interest rate environment seen across the globe. The CBI is also concerned with information asymmetry between the investment manager and the AIFM.
In response to this, the CBI expect a more thorough investigation of the loans contained within QIAIFs. This is expected to begin at the initial stages of the Due Diligence (DD) process and is maintained by conducting on-going credit analysis for the life of the fund. As a response to the CBI’s requirements, Waystone has updated and enhanced its model.
Q: What enhancements has Waystone made?
A: We have enhanced our credit risk analytics and investment oversight capabilities by increasing headcount in the Investment Management Oversight team and hiring credit specialists. This mean we can better work alongside clients to help them meet the additional requirements of the CBI in order to successfully authorise LQIAIFs.
From a regulatory perspective, several enhancements have been introduced to LQIAIF fund governance. The two principal enhancements relate to due diligence and approval of all new deals proposed by the investment manager; and an on-going credit analysis of loan-originations in the fund.
The due dilligence involves conducting a credit review of each loan origination covering an analysis of the borrower business, financial analysis, scenario analysis, loan terms, covenants, investment risk and mitigants and the borrower capital structure. New investments are discussed at the Waystone Credit Committee, to ensure a comprehensive review is conducted.
The second aspect – the on-going analytics of the originations - involve uploading the loan features into the Waystone platform and providing a thorough investigation into the credit risk of each loan. Focusing on the Probability of Default of each loan, we are also able to conduct credit stress testing that is specific to the loans in the fund. In addition, we can isolate the key risk metrics impacting the LQIAIF.
Q: What about for more conventional areas of fixed income? Are there any enhancements there?
A: Yes! Waystone has also introduced bespoke enhancements to other areas of credit including sovereign and corporate bonds; asset-backed securities - including CLOs, RMBS, CMBS and auto loans - and non-performing loans. For example, within CLOs, we have enhanced our ability to model the underlying collateral in these structures, thereby improving the stress test outputs and understanding of the credit risk associated with each tranche in the CLO.
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