Why it matters

Disintermediation in Europe is taking an important step forward. Private lenders, who have been active in the mid-market in Europe for years, took full advantage of tighter funding conditions over the past two years as interest rates rose and banks' lending appetite reduced. This coincided with a transformation of the financing sector that resulted from a confluence of structural factors.

The rapid growth in PC funds and, more broadly, alternative assets resulted from demand and supply effects: 

• Demand: PC funds have addressed unmet financing demands as banks--which remain by far the largest financing source in Europe--have been less willing to provide funding to specific segments, including leveraged finance. This is due to regulatory constraints (capital charges) and supervisory probing (risk management requirements) for high-credit-risk products, such as leveraged loans.
• Supply: PC funds have received vast amounts of capital as long-term capital investors--including sovereign wealth funds, pension funds, and insurance companies, among others--seek high long-term returns on a risk-adjusted basis and are prepared to give up short-term liquidity to achieve that. When rates were low after the global financial crisis, alternative capital was directed mainly toward private equity. Now that rates are normalizing, however, investors' asset allocations are increasingly tilted toward fixed income and PC. Unsurprisingly, established private equity firms saw an opportunity to leverage their connections with existing limited partners (LPs)--external investors in the funds--by further developing their PC capabilities.

The diversification of funding sources is beneficial for the European economy.  It counterbalances the dominance of bank-provided financing in Europe, where banks' assets as a percentage of GDP exceed those of U.S. banks more than threefold. The diversification of funding sources is particularly important in the case of asset-lite, innovative growth companies that require debt financing to scale up, or in the case of long-term debt financing needs to support infrastructure and other projects--activities that banks' balance sheets are less well placed to support. Additionally, private finance funds can channel European funds toward productive investments. Retaining and investing European household savings in Europe, rather than in the U.S., is crucial to improve Europe's productivity and growth potential.

Chart 1

Rapid Growth And Innovations Are Propelling The Asset Class

PC funds have reached a tipping point, with leading PC firms, even in Europe, sitting on record-high amounts of uninvested capital (dry powder). Business models, investment strategies, and funding structures are becoming more diversified.

PC funds are gradually expanding their lending activities from mid-market entities to more credit classes.  The latter include asset-backed financing and securitization of future flows. Larger PC funds are increasingly leveraging life company capital and provide capital solutions to generate yields and returns on a risk-adjusted basis. In Europe, for example, Barings LLC's global private finance platform benefits from access to its parent Massachusetts Mutual Life Insurance Co.'s (MassMutual's) balance sheet. Similarly, Apollo Global Management Inc. (Apollo) can use capital provided by its wholly owned subsidiary Athene Holding Ltd. (Athene) for large bespoke transactions. Recently, Apollo completed the third of three transactions totaling €3 billion. It bought minority stakes in some of Germany's largest real estate company Vonovia SE's affiliates to support Vonovia's deleveraging and maintain operational control of the assets.

PC funds can be funded by private investors if they comply with the Undertakings for the Collective Investment in Transferable Securities (UCITS) framework or the Alternative Investment Fund Managers Directive (AIFMD).  These funds, which now include European Long Term Investment Fund 2.0 (ELTIF 2.0), offer retail investors access to illiquid PC assets. They also provide a degree of liquidity for redemptions at the latest net asset value (NAV) on a monthly or quarterly basis, albeit with a penalty during an initial subscription period. In some cases, more liquid assets--such as leveraged loans, high-yield bonds, and cash--account for 20%-30% of the funds' holdings and act as a buffer to help manage liquidity risks.

PC funds are strengthening their relationships with banks.  PC funds are increasingly accessing banks' distribution platforms, as demonstrated by the strategic partnership between Societe Generale and Brookfield Asset Management that launched a €10 billion private debt fund in September 2023. Additionally, banks are providing more financing, either at the fund level or at the LP level.

Complexity And Risk Potential Increase

The abovementioned innovations could reduce financial stability.  As the complexity and variety of transactions in the private debt industry increase and new investors enter this previously niche asset class, the risk profile of PC funds is changing. Concretely, liquidity risk, leverage, and PC funds' interconnectedness with the rest of the financial system could rise.

A key concern is that some LPs may underestimate the illiquidity of their investments in PC funds.  This happened in 2023 when interest rates rose sharply to counter inflationary pressures. Private equity exits dried up, related loan prepayments reduced, and more portfolio companies used payment-in-kind features to preserve liquidity. As a result, the amount of cash that private equity and PC funds upstreamed to their LPs was considerably lower than in previous years. For instance, some LPs had to adjust their liquidity arrangements and asset allocations by trying to monetize their stakes in private equity and private debt funds through sales to secondary funds or through collateralized fund obligation transactions.

Some PC and private equity funds have responded to this decline in liquidity by adding leverage.  Some PC and private equity funds chose to raise NAV facilities--with the bank loans secured on the net asset value of the funds--to return cash to LPs. While funds are not obliged to do it, some managers preferred to leverage funds to improve the "distributed to paid-in" (DPI) capital metric--which quantifies the amount of capital that has been returned to LPs relative to the capital they invested--to support fundraising for new funds. This points to an increase in leverage, albeit at the fund level, that raises downside risks in the event of a severe market downturn.

Leverage is increasing across the private debt and broader private capital industry, with new forms of financing potentially obscuring true credit quality and creating regulatory arbitrage.  Front of mind in this regard is the levered feeder fund structure model (see chart 2), which is becoming more widespread. This model enables select LPs to subscribe to private debt master funds through a feeder fund, whereby LPs' capital is provided in a blend of debt and equity. This setup enables some LPs--such as pension funds and insurance companies--to record part of their stake in PC funds (sometimes as high as 90%) as debt rather than equity, which may benefit from a preferential capital treatment.

Chart 2

Private debt funds usually have terms of seven to 10 years, with no provision for mandatory scheduled payments to LPs before maturity.  This enables private debt funds to navigate any credit market downturns. However, a feeder fund is often supposed to pay interest on a regular basis to its LPs, even if a deferral option in the documentation exists.

General partners (GPs) are starting to securitize their stakes.  This technique enables the GP to finance the equity contribution to the fund it manages, or the stakes of its partners and employees in this fund, through debt. The GP would create a special purpose vehicle that would borrow against the pledge of the GP's stake in one or more funds and the pledge of future management fees to be received for managing the funds. As a result, the asset manager can reduce their own balance sheet leverage on day one in exchange for lower revenues in the future.

Conflicts of interest could increase.  These could materialize differently:

• Companies' private equity and private debt businesses are increasingly interconnected, with strict information barriers between the two units not always a given. Based on historical evidence, intercreditor relations in the leveraged finance market can become problematic when businesses become distressed, especially if a potential conflict of interest exists.
• Another potential conflict can arise in the case of continuation funds, where a private equity or PC fund rolls assets into a new fund and pays out some investors in the process. The challenge here is to negotiate a market value that is fair for new and existing investors.

Innovate With Caution

The opportunity for PC in Europe is enormous, subject to the right guardrails.  Europe is in dire need of investments to improve its productivity, as underlined by Mario Draghi's report from September 2024. Mobilizing funding from various sources, including private finance, will therefore be a necessity. Yet ensuring a safe and sustainable flow of funds will require significant regulatory efforts and streamlining from EU authorities. Additionally, it will require PC funds to manage the risks they take, while their key stakeholders--the LPs that invest in these funds and the banks that increasingly finance them--also play a part in applying market discipline.

A core lesson from the global financial crisis is that fast growth and financial innovation can create systemic risk as previously underestimated contagion channels can quickly appear when the cycle turns.  Individual banks' or insurers' current exposures to the private finance markets are typically small in Europe, relative to their respective balance sheets. That said, the complexity and lack of transparency on the multiple interlinkages between these institutions and the private finance industry are, in our view, key vulnerabilities that will need to be addressed over time. When the cycle turns, LPs (which invest funds from the general public) could start questioning certain structures, while regulators or the general public could question who holds the ultimate risk in the event of a fund or system failure. The European Central Bank has already flagged that banks struggle to assess their full exposure to PC funds.

Related Research

• Bottleneck In Exits Will Increase Some Alternative Investment Funds' Leverage, Sept. 3, 2024
• Rising Global Defaults Will Test Private Credit Funds In 2024, May 1, 2024