In 2018, for the first time, our firm advised on as many real estate debt fund launches as equity. This shift exemplifies the wider theme of real estate debt becoming a fully established and accepted asset class in its own right in terms of fundraising. Participants finding opportunities through debt funds to fill the gap left by the banks has created a more diversified market of lenders and private credit being a part of investors’ portfolios. Regulations like Basel III, the Volcker Rule and ‘slotting’ in the UK continue to affect the supply of credit to the markets, which offers wider opportunity for debt fund managers. Such regulation is likely to increase, despite certain populist governments advocating to deregulate in some jurisdictions.
Lending activities may not become more straightforward from a regulatory perspective than they are currently and it is challenging to originate debt in some jurisdictions. There is a requirement to have a banking license in certain jurisdictions, or at least an exemption or notification to the national bank or regulator. Some regulators, notably in Germany, have stated that AIFs and AIFMs are exempt from the requirement to have a license for certain activities. This creates some structural issues; the AIF itself may be exempt, but with debt funds the sub structure and lending platform are generally devised at the same time, as opposed to the propco and holdco approach, common in the structuring of equity funds. That said, the sub structure is inherently a different entity to the actual AIF, which complicates the issue of banking and credit licences.
March to Luxembourg
The drive to domicile funds in Luxembourg continues, and this is especially true for credit funds. But care should be taken with certain Luxembourg structures. Luxembourg securitization vehicles are a well-established entity and may be useful, but while their inability to originate debt may not be a significant issue, their inability to enforce a security package without the risk of it no longer being passive, and thus tainting its status, is potentially problematic.
Be aware of conflicts of interest
Managers are launching a wider range of products, resulting in traditionally value-add or opportunistic managers seeking to launch core-plus products, and core-focused financial institutions looking to launch value-add funds. This is also true of equity funds managers launching debt products. Conflicts of interest must be considered to avoid any issues, but this may be handled if the manager implements an appropriate internal structure to its organization. At present, there does not appear to be a significant commonality between investors across these products. However, given the time and effort it takes for investors to perform operational due diligence, some managers may try to attract larger investor commitments and allocate them across their broader product range in the future, depending on the investors’ requirements and risk appetite.
BEPS impacts everything
The much talked about base erosion and profit shifting (BEPS) initiative and the EU’s ATAD and ATAD II directives are now affecting all fund structures. These regulations will affect underlying debt transactions and returns on risk. For example, there is a new rule restricting interest deductibility in the UK, which goes further than the existing interest deductibility rules in jurisdictions such as Germany and will, from 2020, be extended to cover not only onshore but also offshore propcos.
The effects of further restrictions on deductibility of interest on loans will also affect underwriting of the sponsors and the financial covenants on such transactions. It may also affect how sponsors structure these transactions. For example, the so-called ‘public infrastructure exemption’ in the UK does not apply to shareholder debt. This means that structural subordination, a common structure where the senior lender and mezzanine lenders each lend to completely separate borrowers rather than a single borrower with an intercreditor arrangement, would be less attractive.
Private credit has been one of the fastest areas of growth for fundraising, a trend likely to continue, partially fuelled by managers now offering more and broader products, including debt and equity in the same house. However, it is also likely that this sector of the market will continue to receive scrutiny from regulatory authorities, and the global tax changes being introduced will also affect how debt funds are structured and how they do business.