Labour’s tax crackdown would hammer UK private credit sector
LABOUR’S carried interest tax reforms would have a costly impact on the private credit sector and could lead to a talent exodus from the UK, according to legal experts.
The Labour Party has pledged to raise £565m a year by changing the taxation regime for private markets managers’ profits from successful deals, known as carried interest.
Currently, these earnings are taxed as capital gains, levied at a lower rate than income.
“Many private credit funds will have a carried interest arrangement rather than a performance fee arrangement,” said Mark Stapleton, tax partner at law firm Dechert.
“Of course, if these proposals come in, there’s a serious concern that they will all be turned into income, potentially taxable at the highest rates.”
Reports of the proposed
tax changes have mainly centred on private equity firms, which have a more obvious capital gains structure due to their sale of holdings in companies.
One global private markets fund manager told Alternative Credit Investor that it has very little exposure to carry,
with the vast majority of its earnings coming from management fees.
But Stapleton says this is not typical for private credit funds and carried interest is often adopted by the sector’s managers.
“With a private equity fund, they’re selling companies so that’s a
capital gain, but with private credit, it’s often income in nature such as interest payments,” said Stapleton. “But even so, it’s usually possible to make sure that a good proportion of what is returned as carried interest is capital in nature and can get capital gains tax treatment.
“This is especially relevant for distressed debt funds, which can make pull-to-par gains.
"Another example is lending by special situations funds, where the fund may also get something like a warrant alongside a loan that will produce a capital gains return, so that would also have an impact.”
Shadow Chancellor Rachel Reeves (pictured) clarified the proposals last month to indicate that carried interest would continue to be taxed as capital gains if fund managers put their own capital at risk >> 4
Shadow Chancellor Rachel Reeves
Credit: Chris McAndrew / UK Parliament
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With elections in the UK and France this month, it’s safe to say that Western Europe is in a period of political flux.
This, of course, has an impact on the economy in numerous ways, including an erosion of investor confidence.
In the UK, the election result is widely seen as a done deal (although Neil Kinnock should remind us that nothing is certain in politics), while in France, business leaders are keeping quiet before they find out who’s likely to be running the country. But both countries have unclear paths when it comes to future economic policy.
It’s worth thinking about how this plays into central bank decisions on interest rates, which are arguably the most important driver of the future of the private credit industry.
The European Central Bank recently cut rates for the first time in almost five years due to a fall in inflation. The Bank of England is yet to follow suit but has hinted at a summer reduction.
With inflation appearing to be on the decline, that all sounds promising, but would a Labour tax-the-rich agenda and a fiscally unsavvy National Rally approach derail the central banks’ plans?
Adding to the uncertainty is the US election in November, which will be the most important political event of the year in global terms. The Federal Reserve has been slow to commit to rate cuts and is thought to be holding off until after the election, amid constant market speculation.
In a higher-for-longer rate environment with worldwide political uncertainty, it’s more important than ever that the private credit industry offers crucial diversification and risk managed returns.
SUZIE NEUWIRTH EDITOR-IN-CHIEF
cont. from page 1
alongside their investors.
“If Labour wins, it seems clear that pure carried interest, which arguably is the performance-related bonus in the views of the Labour Party, is likely to be impacted,” said Kevin Cummings, partner at law firm McDermott Will & Emery.
“But Labour may leave alone co-investment through carry structures, whereby managers co-invest into funds, which is separate from pure carried interest but also gets capital gains treatment.
“I think that will be a really critical point, as to whether co-investment is also subject to income tax.
“There are stronger economic arguments as to why co-investment should not be subject to income tax and therefore may be excluded from any potential future reform.”
Cummings said that this is “likely to encourage further coinvestment” by private credit fund managers.
Global battle for talent
The other question is whether these tax changes would make the UK uncompetitive on a global scale.
“The real issue is, when one country makes these types of changes in isolation, there’s a
competitive risk that those people that are mobile decide that the tax consequences are no longer as attractive as working elsewhere,” said Stapleton.
“The US is always talking about potentially taxing carried interest as income but then the conversation goes away because there’s a powerful lobby on this point.”
James Burton, global tax partner at A&O Shearman, agrees that the proposed tax changes could have an impact on attracting the best talent.
“The measures proposed by the Labour Party are specifically intended to increase the tax paid by investment fund managers,” he said. “It seems inevitable that those affected will consider the impact of these changes on their personal circumstances.”
However, Burton notes that some other
countries, such as France, have tax regimes for carried interest that include a requirement for capital to be invested.
“In that sense, a similar rule in the UK may not be seen as uncompetitive,” he added. “However, it will depend on the detail.”
Lack of clarity
Uncertainty around the specifics of the new rules is creating worries for private credit fund managers.
Dechert’s Stapleton said that Labour’s proposals are currently a key topic of discussion among his clients.
“They are keen to know what the changes actually mean, as Labour has said that it’s going to close this loophole, but on the other hand they have made it clear that there’s going to be a consultation,” he said.
“My clients are still structuring things in the hope of getting capital
gains on carried interest. It may be optimistic, but there’s the hope that it will take time to get the rules in place or perhaps there will be a compromise, whereby they’re taxed at income but at an intermediate rate. Most clients are worried about it but don’t know what to do at this point as it’s not completely clear.”
Whatever the political climate, private credit is well placed to weather the changes, according to industry stakeholders.
“Private credit has built its business, its reputation and its approach by being incredibly flexible from a capital deployment perspective,” said Aymen Mahmoud, partner at McDermott Will & Emery.
“And I think they're going to be equally that way from a capital management perspective.”
“Death by a thousand paper cuts” as exceptions flood covenants
THE MARKET is holding its breath to see how French telecommunications company Altice’s fight with lenders will play out.
The company carried out a liability management exercise back in March, moving two of its assets, its media business and a majority stake in its data centres, out of the group by designating them as unrestricted subsidiaries. This means they cannot be touched by lenders, as they are now not covered by covenants.
It is a good example of what looser standards can lead to. And it was just eight words that got Altice off the hook, according to Jen Pence, senior credit
officer at Moody’s Ratings.
While in the US there have been a lot of liability management transactions, some of these have gone to court, but judges are usually reluctant to side with lenders who have allowed the flexibility in the first place. As they are considered sophisticated investors, it is difficult for them to make the case that what they have allowed in the documentation should be overturned by a court.
“You have J Crew as the first and everyone watched to see what happened. Some have litigated, others have negotiated outside the courtroom.
Altice and Intralot demonstrate that liability management transactions
have arrived in Europe as well,” Pence told Alternative Credit Investor.
Although issuers are reluctant to change their covenant packages, aggressive provisions are still getting through in sponsored deals, according to Pence.
“You still have a lot of flexibility to undergo liability management transactions…The dynamic has really shifted since sponsors have come on the scene. Banks want good relationships with sponsors as there is the potential to do multiple deals so are hesitant to pushback on aggressive covenant provisions,” she noted.
Pence added that last
year, eight per cent of deals had some pushback, but this year it has risen to 16 per cent.
She calls it “death by a thousand paper cuts”, because there are so many exceptions in loan documents now. Sometimes, exceptions are introduced just for the sake of having exceptions.
“Investors might push back to include a ‘J Crew’ blocker, but depending on the drafting, what teeth that has is very questionable,” she said.
Pence added that she is seeing other changes in the market, such as making the bonds portable from issuance. This means that the loan remains essentially the same when the company changes ownership. This has become more important as private equity owners are frantically seeking exits.
Bridging lenders start to trim their margins
BRIDGING lenders have begun to trim their margins in order to remain competitive in the ongoing high-rate environment.
Speaking at Alternative Credit Investor’s property webinar last month, Andrew Caracciolo, a broker at Tapton Capital, said that a prolonged period of higher interest rates has begun to put pressure on alternative lenders.
“We are seeing a number of lenders, particularly on
the bridging side of things, begin to trim their margins to try and stay competitive and entice the customers in this high-interest-rate place,” Caracciolo said.
“I think towards the end of the year we'll be
seeing some reduction, but it's not going to be as fast or as profound as we expected.”
Fellow panellist Narinder Khattoare, chief executive of Kuflink, confirmed that his peer-to-peer proper-
ty lending platform has already begun to squeeze its margins in response to high interest rates.
“We would like to offer more competitive rates to our borrowers, but it's challenging,” he said.
“I think we will see a couple of rate reductions later on this year, and I think there'll be a few more the year after.”
To read more about the property webinar, go to page 8
Rising demand for bespoke structures
LARGE investors are increasingly opting for bespoke arrangements to access private credit deals, as sponsors offer more flexibility in a challenging fundraising environment.
Single-managed accounts – also known as “fund-of-one” structures – can be structured to suit specific business objectives and often offer more flexibility in terms of fees and holding periods. They can also be set up for tax efficiencies specific to a particular investor.
“Over the past 12 to 18 months we’ve seen a significant increase in the number of bespoke arrangements being put in place for large, strategic
investors,” Matthew Keogh, investment funds partner at law firm Linklaters, told Alternative Credit Investor
“These have included a range of single managed accounts and side cars which have been designed either to sit alongside a primary fund or to enable the investor in question to gain access to deals across a range of products using investment criteria or economics tailored for the investor.”
Private markets fundraising has slowed in recent years, partly due to the denominator effect which left many institutional investors overallocated to alternatives amid public market volatility. Furthermore, a lack of M&A activity has had a knock-on effect on sponsor-backed direct lending, while general macro uncertainty has resulted in caution among some investors.
Keogh said that the rising demand for bespoke arrangements has, in some cases, “been a reaction to pressure being brought to bear by those investors on primary fund terms” but it mainly reflects “a willingness of sponsors to provide more bespoke solutions for large, strategic investors in a more challenging fundraising environment”.
“As a sector, private credit is particularly well suited to these kinds of arrangements given the way deals are structured and it is quite common for sponsors to bring multiple funds and other accounts into underlying opportunities,” he added.
Payment-in-kind income increasingly higher for funds
SOME direct lending funds are seeing an increasing portion of their income come from payment-in-kind (PIK) payments, experts say. Ratings agency Fitch recently issued a report that showed that eight per cent of direct lending business development company income in the US was derived from PIK income.
Principal Asset Management, in a subsequent study, found that an even higher percentage this year is from PIK income,
“demonstrating this trend has only further increased this year,”
Matthew Darrah, head of underwriting for direct lending at Principal Asset Management, told Alternative Credit Investor.
He pointed out that the increase in interest is due to two factors: legacy portfolio company issues that were levered to perfection prior to interest rate rises, and the increasing number of new platforms with PIK toggle transactions seen in the upper middle market, where lenders are
offering higher leverage to compete against the reopened broadly syndicated market.
“This higher leverage can’t be supported if borrowers had to pay in cash, and so instead, those lenders have allowed for PIK,” he added.
In a high interest rate environment and with valuations facing downward pressure, he said the firm prefers to focus on the lower and core middle market, where PIK toggles are far less common and coupons are paid in cash.
According to one investment banker, PIK elements have been narrowing but they are still more prevalent than before rate rises started. However, the banker noted that they are seeing lower spreads offered in the PIK realm.
The banker also reported instances of restructuring debt to PIK or introducing them during negotiations around covenants.
PIKs are also being introduced into the holding company’s balance sheet rather than that of the operating company.
Rise in synthetic risk transfers could pose issues
BANKS across Europe and the US are unloading risk as they look for ways to deal with higher interest rates and new regulations.
The synthetic risk transfer (SRT) market has gained traction is recent years, with banks seeking to free up capital in an attempt to comply with Basel III and Basel IV regulations.
And although many expect the market to continue to grow, there are risks involved due to the complexity of the instruments.
Manisha Baid, associate director of lending services at Acuity Knowledge Services, said SRTs offer banks a way to manage risk and improve capital efficiency, and therefore he expects the market to continue to expand in the near future.
According to the IACPM Synthetic Securitization Market
Volume Survey data, the underlying pool of loans in SRTs was nearing €200bn (£169.1bn) by the end of 2022.
“With the current uncertainty, banks are cautious about holding loans and SRTs function as a hedge transferring some of the risk to investors who are comfortable with it,” said Baid. “Regulators reduce
the quantum of equity banks must hold against the loan portfolio when banks offload credit risk from the riskiest part of the loan portfolio.”
BlackRock recently highlighted SRTs as a growing opportunity for investors within private debt as they will also be boosted by fresh issuances from US banks, with recent regulatory guidance set to make it more attractive.
For institutional investors, SRTs can offer attractive returns, often exceeding 10-15 per cent compared to traditional investments, Baid added.
But with any new investment comes concerns.
“SRTs are complex instruments and valuing the underlying pool is a complex process,” said Baid. “There is a risk of mispricing
from underestimation of the credit risk of the underlying pool of loan, which could result in investors being inadequately compensated. Also, the illiquid nature of SRTs makes it difficult to exit the investment before maturity.”
She also said if banks become less diligent as they offload risk, there could be a buildup of riskier loans in the system and higher defaults in case of an economic downturn.
“There is also a debate about whether this is really a transfer of risk,” she added. “A sizable portion of investment comes from private credit investors, who in turn have credit financing lines from the banks, essentially bringing the risk back to the banks. Though there are concentration limits,
it may still contribute to the overall systemic risk.”
But currently, the SRT pool is not large enough to impact financial markets overall. With restrictions on total transfer volumes, banks prefer SRTs with upfront cash collateralisation and investors are conducting robust stress testing, according to Baid.
Jonathan Sloan, in the portfolio valuation group at investment bank Houlihan Lokey, said he is currently seeing issuances through SPVs with asset classes including auto, student and corporate loans, as well as corporate revolver collateral.
There are increased inquiries from Asia, he added, and there is a lot of activity with issuances by European banks.
In the US, funds that are seeking to be protection sellers are continually looking for investment opportunities, he noted.
“While we expect the SRT market in the US to be an avenue banks explore for both capital relief and risk mitigation purposes, the expectation of significant growth of SRTs from large US banks was dampened by the Fed’s thoughts on modifying Basel III endgame rules,” Sloan told Alternative Credit Investor
Making a positive impact with peer-to-peer property lending
Alternative Credit Investor hosted a webinar, supported by Kuflink, focused on the UK property market and investment opportunities within peer-to-peer lending. Stakeholders are moderately optimistic but planning reforms remain high on the wish list. Kathryn Gaw reports
THE
UK
PROPERTY
market is in the midst of a long-awaited recovery. According to Knight Frank, house prices are up by around a fifth since the last general election, and housebuilding is being listed as a key priority for every party on the election ballot this year.
However, challenges persist in the property lending sector. Issues around affordability and lack of new housing have squeezed the residential property market; while a persistently high rate environment has led to a higher risk of borrower defaults. And then there are the costly delays in planning permissions, and the limitations of regulation.
Meanwhile, it is becoming increasingly clear that peer-topeer property investors will not simply be content with marketbeating returns. According to the results of an exclusive Alternative Credit Investor survey, investors value portfolio diversification, data transparency, collateral and the reputation of the company’s management.
On Thursday 13 June, Alternative Credit Investor co-hosted a webinar along with Kuflink which brought together a panel of UK property
experts to discuss these ongoing challenges and the opportunities for investors and borrowers alike.
The webinar was led by Narinder Khattoare, chief executive of Kuflink, Andrew Caracciolo, a broker at Tapton Capital, and Anna Ward, associate and senior analyst at Knight Frank; and moderated by Suzie Neuwirth, editor-in-chief of Alternative Credit Investor.
Over the course of the morning, the panel discussed the ins and outs of UK property lending, and how the sector is likely to change in the year ahead.
“Affordability is the hot topic,” said Ward. “Obviously, both sides of the fence have promised to
at least see a bit more momentum and a bit more confidence as well in the market, particularly as interest rate cuts start to come into view.”
Kuflink’s Khattoare agreed that planning issues represent one of the biggest challenges for P2P property lending. The government has set a target of building 300,000 houses per year, yet this target is unlikely to be met.
“We've worked with a number of developers who are having major challenges with council planning rules,” said Khattoare. “The planning laws need to change.”
Tapton’s Caracciolo echoed the need for better planning processes, revealing that very few private
“ We've seen planning permissions fall to a decade low”
ramp up house building. But in terms of how realistic that is, the indicators that we track at Knight Frank do suggest that their targets are probably quite unrealistic.
“We've seen planning permissions fall to a decade low. In terms of what would be coming out of the ground, I think it's pretty unrealistic. But equally, It is a pivotal moment for the house building sector, and we should
equity firms are now willing to work on any property projects which are in the pre-planning stage, as it represents too high a risk.
The panellists also agreed that rate reductions are likely to come into force later this year, and this will have a knock-on effect on borrowers and investors. Over the past decade, UK property has seen some unusually low rates, with mortgage
offers as low as 1.95 per cent at one point, and bridging loans being offered at as little as six per cent.
But barring some unforeseen financial event, we now appear to be squarely in the midst of a ‘higher for longer’ interest rate environment. In June 2024, the Bank of England maintained the base rate at a 15-year high of 5.25 per cent. While rate drops are expected towards the end of the year, lenders have been forced to adapt to these new market conditions, raising rates for borrowers in turn.
Caracciolo believes that these higher rates have led to more creativity in the lending sector.
“We're seeing them become a lot more amenable to more unusual structures in how the developers are going to fund the deals, deferred considerations being one of them,” he said.
“Previously, if a developer was seen to be doing that, lenders would be pretty uneasy about the concept. We're seeing that really opening up now because they accept that it's got to be done to make it viable.”
Higher rates means higher costs for borrowers, and higher returns for investors. However, Khattoare urged investors to look beyond the interest
rates on offer when choosing which property loans to back. Instead, he has encouraged diversity with a mix of locations and risk profiles in each property loan portfolio.
Alternative Credit Investor’s survey found that investors are largely in line with Khattoare’s philosophy.
Just 38.1 per cent of respondents said that higher returns were the most attractive element of an investment. Instead, these investors valued data transparency and diversified risk above everything else, with collateral and the reputation of company management also scoring highly. These responses didn’t come as a surprise to Khattoare.
“We are seeing that people are looking to diversify their portfolios,” he said. “We've seen a shift from our investor database where they were investing into individual projects. Now they're diversifying it, spreading it across a number of different types of loans.”
“Collateral has been a huge thing for our clients, particularly on the lending side,” agreed Caracciolo.
“I think it's really essential to make sure you're fully informed on that when you're going into these investments.”
When asked to predict what the next 12 months had in store, the panellists were circumspect, with new opportunities on the horizon, and the possibility of a new government in a matter of weeks.
“The sentiment is definitely improving,” said Ward. “Demand is picking up slightly, but it's really just down to that performance in second half of the year. I do think we should see a massive improvement once the election is out of the way and the Bank of England starts cutting rates.”
“I think the sector is going to be fairly buoyant,” added Caracciolo. “If we do get these rates decreased, it's going to help on the viability of schemes and the affordability for the end purchaser.
“As improved market sentiment trickles down, perhaps that will feed into the valuers who are particularly pessimistic. A lot of the loans which we do are plagued by down valuations at the moment. There's still a fair bit of pessimism on that side of the market. So hopefully that will lift and be in a good place.”
For Khattoare, steady growth is expected in the UK property market, with pockets of high growth in some regions.
“If we're going to see any growth, it will be very steady growth,” said Khattoare. “I do still think there will be an interest rate cut, but I think it'll be more or less the same. I've seen a bit more stock coming back on the market. But I think the key thing here is the election.”
Stability would be a welcome tonic for alternative property investors, but the panel discussion and survey results show that these investors are sophisticated enough to assess their portfolio risk and maintain diversity to offset any potential losses.
Alternative Credit
The Alternative Credit Awards, hosted by Alternative Credit Investor, will take place on 6 November 2024 at the Royal Lancaster London.
The winners of the awards will be announced on the night, celebrating the most influential fund managers, lenders and service providers making their mark on the alternative credit space.
Attendees can expect a glittering evening, comprising a drinks reception, gala dinner and awards ceremony.
For more details, please go to the Awards section of the Alternative Credit Investor website (alternativecreditinvestor.com)
For queries regarding table sales, please contact sales and marketing manager Tehmeena Khan at tehmeena@alternativecreditinvestor.com.
Credit Awards 2024
A piece of the pie
Everybody seems to want a piece of the direct lending market at the moment. But as a multitude of new opportunities hit the market, investors should be prepared to up their due diligence, Kathryn Gaw reports.
DIRECT LENDING IS arguably the hottest segment in private credit right now. According to a recent report from Allianz, it is direct lending that has fuelled the impressive growth of the private debt market over the past five years, and its impact is set to continue for the foreseeable future.
Earlier this year, JPMorgan’s 2024 Long-Term Capital Market Assumptions report suggested that direct lending would likely deliver annual total returns in excess of 8.5 per cent over the next 10 years, with even higher returns predicted for the year ahead. While default rates are expected to rise, JPMorgan noted that investors will be “well compensated” for this risk.
However, direct lending's rapid growth has inevitably resulted in fierce competition for deals. The more established direct lending fund managers are securing the majority of market share, but they are increasingly facing pressure from both the upper and lower ends of the market, as investment banks and new direct lenders begin to push into the space. Meanwhile, a lack of deal activity and an abundance of capital has highlighted the importance of active fund management and strong networks, leading to a bifurcation in the ever-popular mid market.
Earlier this year, Morningstar DBRS reported that issuers rated CCC (high) or lower now represent six per cent of its portfolio – up from
two per cent at the end of 2022, with downgrades outpacing upgrades by 2.6 times in the first quarter of 2024. However, the credit agency also noted that the upper end of the market was thriving, indicating an emerging schism in fund quality. This variation in direct lending funds has underlined the importance of active portfolio management, sector expertise and detailed investor due diligence.
“ Ultimately, private credit is about people and trust and expertise”
“Ultimately, private credit is about people and trust and expertise,” says Alex Di Santo, head of private equity, Europe, at fund administrator Gen II.
“We’ve seen a lot of people hear about the success of private credit and try and move into that space. But if you don't have the expertise and the right team to be able to deliver that, it's very difficult. It's a very different skillset, and a very different type of arrangement.
“It takes time to build that infrastructure and build those networks. If you take a couple of key people out of those businesses, it could all fall apart quickly.”
Established private debt funds have an advantage in this space, as they have the connections and
the track record to secure deals before their competitors even know that they exist. However, even established private credit players are learning that direct lending is a uniquely challenging segment.
In October 2023, Fidelity International launched its first direct lending fund in Europe and closed its first deal – a senior financing agreement with the Clinias Dental Group based in the Netherlands.
Yet just seven months later, the firm confirmed that it was exiting the direct lending space altogether, following the departure of Andrew McCaffery, the firm’s long-standing co-chief investment officer for fixed income, multi asset and private assets. Fidelity
“ Massive pockets of capital have come into the space”
declined to comment to Alternative Credit Investor when approached for additional information on the exit from direct lending.
Even the largest banks are finding that it is not easy to enter this space and maintain their market share.
Banks typically prefer to make larger loans to investment grade borrowers, but over the past few years, private credit fund managers have been inching ever closer to this once-impenetrable territory.
“Direct lenders are more willing
to compete on pricing to win lower levered senior deals, where banks have typically focused,” explains Tim Warrick, managing director of alternative credit at Principal Asset Management.
“We are witnessing significant delineation across the direct lending market, with large firms oftentimes moving more ‘upmarket’ in order to deploy the significant capital they have raised.
“This drives increased demand for larger deals and puts the upper middle market and larger private credit market in direct competition with the public high-yield market.”
In recent years, banks have shown a greater appetite to partner with private credit funds on these upper mid-market deals, raising the possibility of increased collaboration or even consolidation in the near future, as the demand for direct lending opportunities grows.
“Massive pockets of capital have come into the space,” says Adam J. Weiss, managing director of credit at Petra Funds.
“Many banks such as Wells Fargo and Barclays have partnered together for direct lending and private credit pushes. There's also been a large increase lately in the registered independent adviser channel looking to go into private credit as well.”
For now, all of this excitement is creating something of a bottleneck. The number of M&A transactions fell by 15 per cent last year compared with 2022, which has limited the number of deals available to direct lending managers. This has led to an environment where there is more capital but fewer opportunities to deploy it, intensifying the competition for new deals.
Furthermore, most fund
managers appear to be focusing on the same direct lending segment of mid-market deals.
Last month, Principal Asset Management launched the Principal Private Credit Fund I, offering exposure to lower and core middle market loans. And Pemberton Asset Management recently revealed that it is looking to raise more than €4bn (£3.4bn) for the fourth vintage of its mid-market debt fund.
However, there is enormous variation in the mid market. The mid-market is typically defined as funds which cover deals worth between $50m and $100m. In the upper midmarket, private debt funds are competing against global banks
“ Smaller lenders may have to take on more risk to acquire their ‘optimal’ portfolio”
for the best quality deals. But towards the lower end of the mid-market, smaller and newer lenders are seizing their chance to steal market share from the bigger players by offering more flexible lending solutions and covenant-light deals in order to secure new contracts.
“That has been a slowly developing trend over the past few years,” says Di Santo.
“People are thinking of more novel ways and more flexible ways to offer these type of products, and I think that will continue for sure.”
This is a particular issue with deals which were originated between 2020 and 2022, as they were underwritten with higher leverage when interest rates were at an all-time low. As some of these loans approach maturity or seek refinancing, weaker businesses may struggle to afford the new rate of interest, which can increase the risk of a default.
“This is why the reporting is so important,” says Di Santo. “You need to make sure you're
getting weekly reporting on those loans. Due diligence is massively important in that process.”
In direct lending, the key risk is that the underlying borrower will be unable to repay the loan within the agreed term time. If refinancing solutions cannot be agreed, fund managers may have to resort to calling in collateral or accepting a lower value to close off a troubled deal. This makes due diligence extremely important for fund managers and investors alike.
“This paradigm has caused stress in the market for those who may be in a position to have to refinance, making the process more costly as well as extend duration,” says Jason Meklinsky, chief revenue and strategy officer at Socium Fund Services.
Meklinsky believes that bigger lenders such as established private credit fund managers and investment banks are in a better position to weather any potential default risk than smaller lenders.
“The larger lenders have a bigger set of opportunities to lend to and can often hold themselves to higher lending standards,” he says. “The smaller lenders may have to take on more risk to acquire their ‘optimal’ portfolio.”
However, this may be merely a temporary issue for the sector. There are some early signs that the lending environment could improve by the end of this year. Most economists believe that the Bank of England will finally start to make cuts to the base rate in August, which will ease the pressure on borrowers and should lead to a boost in funding requests. Meanwhile, a number of industry insiders told Alternative Credit Investor that they expect transaction activity to pick up towards the end of the year, with
“ Direct lending remains in the relatively early stage of what will be continued growth for years to come”
an increase in the pace of leveraged buyouts and M&A activity. This suggests that the current deal drought could soon come to an end.
“Though risk premiums have compressed somewhat for direct lending, we believe the value proposition for investors will continue to be attractive as public market risk premiums are quite compressed,” says Warrick.
“In addition, lower middle market and certain core middle market direct lending opportunities continue to provide attractive credit structures, with reasonable leverage and covenants, in addition to relatively attractive pricing compared to larger transactions.
“We believe direct lending remains in the relatively early stage of what will be continued growth for years to come.”
Investor demand for direct lending funds is only getting higher, so for fund managers the challenge will be to meet this demand without risking the reputation of the sector by accepting lower quality loans at unrealistic rates. Manager expertise has never been more important, at least until deal activity picks up and economic conditions improve. Until then, the competition for quality will make this a particularly interesting private credit segment to watch.
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Lendermarket’s year of change
IT HAS BEEN approximately 12 months since Carles Federico took over the reins at Lendermarket, and a lot has changed since then.
Earlier this year the Dublin-based peer-to-peer lending platform underwent something of a rebrand with the launch of Lendermarket 2.0, which streamlined the investment process for the platform’s users and improved transparency for investors.
The P2P marketplace has also added new loan originators and signalled its intention to onboard even more lenders in the near future. Meanwhile, the company has been able to maintain its zero capital loss record thanks to its buyback guarantee scheme; while offering annual returns of between 15 and 18 per cent.
But Federico won’t take all the credit for the platform’s recent success.
“Everyone at Lendermarket is super committed, very investororiented,” says Federico.
“It's been easy to onboard in a company where everyone is so committed and so looking forward for the same goal.
“Sometimes you arrive to a company and you have to modify half of it because it's not valid. But not in this case – Lendermarket has an amazing team.”
Before joining Lendermarket, Federico was an active P2P investor himself, as well as a seasoned fintech professional. He had already identified Lendermarket as one of the more innovative platforms in the European P2P market, even before the changes of the past year.
“I believe in anything that is innovative and that is changing the physical into the online,” he explains.
However, in order to be truly innovative you can’t stand still, and Federico has big plans to work on Lendermarket’s growth and development in the years ahead.
He is currently hiring new IT professionals to further streamline and improve the online investor experience, and he is searching for new loan originators from around the world in order to give investors more options.
“Everything is shifting towards more customeroriented goals,” he says.
“Our growth is going to be based on diversification. I feel that at the moment we need more loan originators, so people have more choice on where to invest their funds.”
These new loan originators could be based anywhere in the world, although Federico is particularly keen to expand into the Latin American market.
The platform currently works with originators in Mexico and Colombia, as well as originators based in Africa and Europe.
In the year ahead, Federico would like to continue to add new products, improve the customer experience and remain competitive in the everchanging European market.
“In the last few years, the P2P industry has grown a lot,” says Federico.
“There is much more competition. That's something that you can feel, that there is a bigger base of operators, but at the same time, we also have a lot of interest from investors.
“I would say that the competition is growing, but interest in our products is also growing so it all equals out.”
Under Federico’s leadership, Lendermarket is poised to take an even larger share of the P2P market, by continuing to prioritise the customer experience and offer even more lending opportunities.
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