hedge fund credit boom

The dearth of bank credit could spark a boom in credit funds, with the aid of impending Irish regulation.

The fund industry is preparing an attack on business that was formerly the preserve of banks, after the Central Bank of Ireland said it will allow funds distributed across Europe to lend money directly to companies from January.

“There is definitely an appetite for it,” says Pat Lardner, chief executive of the Irish Funds Industry Association.“ You could say it is a new framework, and it is still very small in Europe, but we think it’s got legs.”

The funds will be regulated under the Alternative Investment Fund Managers Directive, meaning they can be authorized for distribution across the European Union. While funds can already buy and sell private loans, the new regulation will allow them to originate loans as well.

This move has been welcomed by hedge fund managers already dealing in credit. “We participated in the Irish government’s review into direct lending funds and are pleased with the result,” says Max Mitchell, director of the credit fund management team at Intermediate Capital Group. ICG specializes in mezzanine finance, leveraged credit and minority equity. “The decision enables us to consider Ireland as a domicile for some of our funds in future.”

Hedge fund managers with one of two areas of expertise are likely to enter the market, says Mr Lardner. “Those who have deep experience of a sector, or those who have deep experience of a particular part of the capital structure” are good candidates for this investment area, he thinks.

Not everyone is confident letting hedge funds loose on the lending market is a good idea. “There is a bit of concern in the market,” says Gary Brackenridge, head of Linedata’s hedge fund business. “People are saying ‘You shut down this market to people who have been doing it for a hundred years, and now you are going to let us do it?’”

The Irish central bank is confident this is not a risk.

“A series of rules have been imposed with regard to credit management, monitoring and management, leverage, stress testing, links to credit institutions, diversification and liquidity, and disclosure,” says a spokesperson. “In our judgment, having consulted widely, including with the ESRB [European Systemic Risk Board], this is a substantial, detailed and robust regulatory regime.”

Despite his qualms, Mr Brackenridge expects some hedge funds will take advantage of this to create a new line of business. US-based managers with experience of this sector (US hedge funds have been allowed to do direct lending for some years) or European funds with “a pressing need to find exposure that fits their profile” are the most likely participants, he believes.

This “pressing need” comes as a result of the low interest rate environment that makes it hard for investors in fixed income to meet their yield requirements. Allowing hedge funds to lend to companies directly goes some way to solving that problem, while also helping mitigate a broader problem, a financing gap that “is not going to disappear any time soon”, as Mr Lardner puts it.

With European economies struggling to get moving again, and banks reluctant to lend to small and medium-sized businesses, politicians and business leaders are keen to see credit flowing. Asset management is an obvious source of capital, so this seems to kill two birds with one stone.

Some commentators have raised the question of whether asset managers have the capability to manage the credit assessment for small companies seeking loans, pointing out that banks used to have entire divisions for this purpose. “We do not see a surplus of operational capacity waiting on the sidelines,” says Mr Brackenridge. He adds that potential investors are not going to accept a lower quality of due diligence than a bank would have found acceptable.

This points to one possible solution. “Hedge funds don’t have a whole set of credit-processing guys lying around waiting to be repurposed. Banks do.” Mr Brackenridge suggests outsourcing to banks that are no longer using their loan origination teams might be the answer to the hedge funds’ problem.

This partnership concept has already been implemented, with credit specialist BlueBay teaming up with Barclays Bank.

A possible uplift in fees is another attraction of this area for hedge funds. According to a report issued by Moody’s, the rating agency, in July, “despite pressure from investors to lower fees, the aggregate amount of fees generated by private debt funds are significantly higher than fees of traditional debt funds. In addition, private debt funds typically give asset managers the opportunity to take a portion of returns in the form of a performance fee.”