How are fund managers navigating the new non-bank lending landscape in Europe?

The credit fund opportunity

Citi OpenInvestorSM

Contents

The new lending opportunity for credit funds (introduction) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

The great deleveraging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

The new bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

The North American experience . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Birth of Europe’s new lending market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The new debt investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Operational challenges and solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Intermediaries: their role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Five tips for successful debt investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Making a success of new opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Guest and Citi contributors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 4

The credit fund opportunity | Contents

1The credit fund opportunity | The new lending opportunity for credit funds

This report looks at:

• How banks are deleveraging.

• The new opportunities for investors.

• How hedge funds and private equity funds are adapting to this new ecosystem.

• The operational challenges that investors and fund managers may face.

• How these new structures will evolve.

This style of banking is still a work in progress. Entrants into this market will require a new legislative framework, evolving operating structures, new staff skill sets, and a deeper understanding of pricing and credit risk. Many questions about its final shape remain unresolved: What will it take to succeed? How will the system evolve? What impact will its rise have on the economy?

However, we do have the benefit of hindsight: two decades of bank disintermediation in the United States have given the industry a number of lessons about what works and what does not in non-bank lending, and a strong sense of how debt might trade in a world where the bank is no longer the only main player. At the same time, we need to acknowledge the limits of that example to European circumstance. Even now, as a European bank union seems to be taking tentative shape, a single non-bank lending market remains a distant dream. This fact should be kept in mind when considering a European lending investment, as this regulatory fragmentation is certain to affect the nature of the opportunity and its operational complexity.

Peter Salvage Head Alternative Investment Services EMEA, Citi Securities and Fund Services

Andrew Mulley Head of Issuer Services EMEA, Citi Securities and Fund Services

Kamran Anwar Head of Private Equity Services EMEA, Citi Securities and Fund Services

The new lending opportunity for credit fundsEuropean banking is changing. The structural developments mandated by Basel III other national-level regulations and the overall environment in Europe are creating a new set of opportunities for investors and borrowers, along with a new set of risks and responsibilities.

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Now a new cycle is underway, which could make direct lending play a more important part of Europe’s economic life. Expectations are that the financial crisis of 2008 and 2009 may lead to an important new role for banks and non-bank financial institutions.

Following the crisis, the regulators’ idea was not to stop growth but to create ways of sustaining it. However, as is often the case, the systemic change ordered in the Basel III accord and other national-level rule changes are already having an impact on the market that may go far beyond its intended effect of limiting leverage within certain bounds.

“Many borrowers may struggle to find lenders who can meet their credit needs. It is this gap in the availability of credit that matters and credit funds are beginning to help address this issue,” says John Reidy, Director, Alternative Investments Client & Sales Management, Citi Securities and Fund Services.

There are a number of investors looking to actively exploit this withdrawal. “We know from our own experience that banks have been quite constructive in the non-investment grade space,” says Matt King, Managing Director, Credit Strategist, Citi Research. The money is going in this direction as margins and fees look attractive, but investors and managers are entering with care. Overall, there is more scrutiny by the banks that are not withdrawing completely.

However, most market watchers do not think the current state of affairs can last forever, and when the shift occurs, the disintermediation of banking — or perhaps more precisely, dislocation of debt — will have at least three effects.

1. One is a shortage of capital for many companies, according to analysts. “Before, buyers of credit were able to do a lot of covenant-light deals and had a lot more control over the destiny of their borrowing. Now it’s flipped around the other way: the suppliers of credit are now very much more in control and demanding higher yields on the loans they provide,” says Reidy.

2. Bank divestments of non-core holdings and exits from the higher-risk corners of the lending market should create an investment opportunity that could be worth between USD1 and USD2 trillion over the next decade, according to International Monetary Fund estimates.

3. Banks will be forced to further develop their skills as advisers and administrators. New market entrants, or existing groups looking to create new products to replace old structures, have an opportunity.

High-yield bonds will fill some of the gap. However, there are reasons to believe that many borrowers will prefer to borrow more directly. Jonathan Butler, Head of European Leveraged Finance for Pramerica, says that for some private companies, the privacy possible with direct loans is attractive. Bonds require communications with investors and regular reports detailing how a strategy is working out – a valuable advantage in an edgy market.

For a private company, on the other hand, loans can be a confidential matter between you and your lender. “You can keep your company far more confidential and you can keep yourself out of the limelight if you’re restructuring,” he says.

The great deleveragingIn the wake of 2008, regulators across the world concluded that high leverage had been a major contributor to the problems that arose. To avoid similar events, national and international regulators raised the capital reserve and credit quality requirements on their banks, along with a variety of other operational restrictions.

”The systemic change ordered in the Basel III accord and other national level rule changes are already having an impact on the market that may go far beyond its intended effect.”

3The credit fund opportunity | The great deleveraging

The North American experience

By examining the experiences of the more mature North American market, it is possible to get a sense of how European financial services may evolve.

In the 1950s, banks controlled more than 75% of lending in the United States. Today, that ratio has dropped to less than a third. This growth of non-bank lending unlocked a vast new source of credit for everyone from students to consumers to corporations. It has also been seen as one of the drivers for the economic downturn. Post 2008, the American non-bank-lending market is strong again. In October 2012, institutional investors bought over USD20+ billion of new debt and rolled over nearly USD40 billion (see graph below).

It will take time before the European market is as strong as borrowers’ appetite for credit. In the US, confidence was build via the Resolution Trust Corporation. It also encouraged the market adoption. Europe is also more fragmented. “Foreclosing in Germany is very different than in the UK and very different in France. Foreclosing in Massachusetts is not that different from foreclosing in California,” says Tyndaris’ Edwards.

The new bank

This evolution of banking may create more opportunities for Europe’s borrowers and debt investors. The deeper and broader pool of liquidity that is now growing in the non-bank credit market will be much less reliant on the balance sheets of a few institutions.

Analysts believe, that European banks are likely to switch from holders of debt to administrators who provide many services, before, during, and after a loan is made. Many may focus on creating sustainable service relationships between borrowers and investors. As in many other industries, the key to a bank’s economic value is likely to be more and more centred on its knowledge, relationships, and insights, and less on purely holding deposits and making its own loans.

US financial market split by equity and credit

Stock market

Private bond market capitalisation

Private credit by other financial institutions

Private credit by deposit money banks

Note: “Other financial institutions” comprise (a) bank-like institutions (that include, e.g. savings banks, cooperative banks, mortgage banks, building societies, and finance companies), (b) insurance companies, (c) private pension and provident funds, (d) pooled investment schemes (e.g. mutual funds), and (d) development banks. Bank-like institutions in the non-US countries shown are mostly classified as banks thus “private credit by other financial institutions” in these countries is nil or insignificant.

Source: OECD, based on World Bank Database on Financial Development and Structure.

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40

20

0

199

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199

5

199

7

199

9

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200

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200

5

200

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200

9

%

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Banks will be able to take only a fraction of the entire demand: European banks need to reduce their asset base by USD2.6 trillion, with 25% from lower lending and 75% from asset sales or profit retention.1

It’s important to realise the European debt market is larger than the US, more heterogeneous and complex. Liquidity and legal standards vary widely within the 27 member states and the instruments are also far from standardised. Moreover, to make things even more difficult, it is divided by the nature of the loan.

Leveraged loansUnlike other kinds of lending, the transition away from leveraged loans by banks has been measured. “While there have been some en masse distress loan portfolios, the paring back of the role of the banks within leveraged loans is quite gradual,” says Fiona Hagdrup, Fund Manager — Leveraged Finance Group M&G Investments, in London.

However, demand is likely to intensify next year, Hagdrup says, because the collateralised loan obligation market remains frozen, cutting off a second source of capital.

Leveraged bank loan activity dropped by 42% in the first nine months of 2012, to USD72 billion.2 Much of this is a reflection of a long-term drop

in demand, however. Buyout deals slumped to USD18.7 billion in Europe in 2012 from USD152.7 billion for the same period of 2007, according to Thomson Reuters.

Most of the sector is focused now not on new loans but on maintaining the USD200-plus billion in existing stock, either by making new loans or floating a bond issue. High-yield, B-rated issues are increasingly common among leveraged buyout issuers.

Overall, in leveraged loans, Hagdrup argues that today it is not so much that banks are being disintermediated as investors are becoming more involved.

Real estate loans“We’re hitting a massive maturity wall,” says Steven Edwards, a Partner at Tyndaris LLP, an alternative investment firm with a real estate credit fund.

Over the next four years, EUR1 trillion of Europe’s EUR1.8 trillion of commercial real estate debt is maturing. A significant portion of those EUR1.8 trillion in loans were made at the peak of the market at 80% loan-to-value in 2006-2007 on a five to seven year term.

These loans are just beginning to enter their maturity period while property valuations have declined 20%, on average, from their market peak thereby compounding issues for bank portfolios. Moreover, due to portfolio and regulatory capital issues, historic lenders have either exited or curtailed their lending activities. When they do lend banks tend to do so at lower LTV’s and only on high quality assets, leaving a significant amount of outstanding debt with few refinancing avenues.

In all, Edwards says, citing commercial property firm CBRE estimates, nearly 50% of commercial real estate debt is highly leveraged with half that amount secured by poor quality assets.

Birth of Europe’s new lending marketOver the next five years, Standard & Poor’s forecasts that Europe will need upwards of USD2 trillion in new commercial debt to keep the economy growing.

5The credit fund opportunity | Birth of Europe’s new lending market

Not surprisingly, a number of lenders and investors have left the market. GE Capital, an active commercial real estate investor in Europe for the past decade, announced plans in August 2012 to stop buying real estate and to invest in senior debt instead3. BlackRock is also looking at setting up a senior debt operation in Europe. “It’ll be a terrific opportunity for us in the next half decade,” said Jack Chandler, Head of Global Real Estate at BlackRock, in New York last June4.

New investors looking at this space include insurance companies but, like banks, they focus on high-quality assets to lend. Moreover, Solvency II (the post-credit crunch accord that aims to prevent future meltdowns of insurance portfolios) limits insurance companies to investing in those areas.

Edwards notes the many structural hurdles facing insurers. “US origination is based on many years of building the infrastructure of origination, risk management and all the operations that go with that, in a very uniform and commoditised market.”

Mezzanine loansMezzanine loan volumes reached USD500 million between 30 June 2011 and 30 June 2012. The previous year, ending 30 June 2011, mezzanine loan volumes only reached USD450 million. Loan-to-value on those loans were holding steady, at 82%. Returns declined slightly, to 15.6% from 15.9% in 2011. The market does seem to be maturing as the number of lenders contracted to 54 in 2012 (from 69 in 2011).5

Trading bricks for bps

Tyndaris is one of a number of firms whose principals see greater opportunity in real estate credit investing rather than direct ownership of real estate.

Led by Raffaele Costa, a veteran of the hedge fund GLG, Tyndaris examined the European real estate markets and it became clear that the massive imbalances in the real estate credit markets would give superior risk adjusted returns to investors over a sustained period when compared to direct ownership of property. “We joined to start a real estate credit investment strategy in Europe, sharing Raf’s vision that the opportunity isn’t on the equity side, the real opportunity is in credit investing,” explains Edwards at Tyndaris.

Tyndaris is not focused on distressed commercial real estate mortgages. “We see that as an opportunity that may emerge in more attractive terms later as we go through a long disintermediation,” explains Edwards. Instead, the firm is looking toward origination. “Where we see the attraction is in direct origination of credit, where we can get equity-like returns, but in a priority capital position.”

The group is looking to invest above the 60% loan-to-value that banks now offer, and opportunistic senior financing for repositioning plays (the kind most banks currently shy away from). However, they are cautious and focus largely on opportunities in the United Kingdom and Germany – the two European markets that have the most investment volume, the best market data, and the most transparent legal systems. “It’s very clear how you take collateral and how in the event of enforcement you get that collateral back,” Edwards says.

1 IMF Staff Discussion Note, December 2012: Shadow Banking: Economics and Policy.

2 Reuters, 10 October 2012.3 CoStarfinance blog, http:///www.costarfinance.com/

anyblogname, accessed on 28 August 2012.4 PERE, 13 Jun 2012.5 CBRE Market View EMEA Mezzanine Lending Market H1 2012

”The paring back of the role of the banks within leveraged loans has been quite gradual, but it is likely to intensify as the collateralised loan obligation market remains frozen.”

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The most prominent non-bank lenders entering the market are credit funds which have private equity and hedge fund characteristics in terms of the strategic or long-term focus, respectively. Below we summarise some of the reasons why these firms are drawn to the market.

Hedge fundsMost hedge funds that specialise in debt focus on credit quality, according to Peter Salvage, Managing Director, Head Alternative Investment Services EMEA, Citi Securities and Fund Services. Typically, they are looking for mispriced debt and operate on a portfolio basis, acting on shorter-term cycles than private equity players.

Hedge funds are drawn toward debt as part of the global hunt for yield. In a low-yield environment, the current supply look attractive. In the US, hedge funds specialising in mortgages were 2012’s top performers. According to data compiled by Bloomberg, “Mortgage securities outpaced every other strategy, with an average return of 20.2%, against an industry average of just 1.3%.”1 This is supported by Reuters which notes that mortgage funds produced returns of almost 19% for 2012. This is well above the other hedge fund strategies (average hedge fund gained 6% in 2012) and ahead of the S&P 500 stock index, which rose 13%.2 Reuters go on to note that the average global hedge fund gained only 3.17 percent for 2012 while the S&P 500 index ended the year with a 13.4 percent gain, excluding dividends.

Private equityPrivate equity funds typically invest into the equity of an entity as they evaluate creditworthiness and potential returns. They usually include a mezzanine investment that is bilateral in nature. These managers are likely to be attracted to this opportunity as an alternative to the traditional model, which has become more challenging due to the lack of sufficient credit at the deal level and the difficulty in sustaining past return performance.

Credit funds also provide an interesting diversification play for traditional private equity firms, which can be potentially attractive to their limited partners.

Hybrid credit fundsSince the experience of 2008 and 2009, when a number of hedge funds suffered because of sudden redemptions, closed-end structures have grown in popularity as a way to prevent investor volatility from unravelling a strategy. Hybrid funds combine the flexibility of a hedge fund with the locked-in features typical of private equity. This capital call distribution model allows the manager to control when capital is entering and leaving the fund. “They don’t need to worry about having to sell when the market is against them,” says Salvage.

But getting that benefit has a price in that it creates a new set of operational and administrative challenges.

The operational challenge may be especially great for hybrid managers who oversee a variety of assets, such as bonds and loans. The time horizon for bank loans and other distressed assets is much longer than typical for equities, bonds and derivatives. This leads to different levels of liquidity and different tax liabilities that stem from the difference between capital gains and trading income, the investors’ domicile, and their tax status.

Traditional lendersIt is important to note that some of these will be traditional lenders from outside Europe. For example, Asian banks are believed to be looking to buy up some of these portfolios in order to secure a foothold in the European market.

The new debt investorsNew intermediaries are emerging that may take up part of the role Europe’s banks are beginning to shed.

1 Reuters, Hedge fund scorecard 2012: Mortgage masters win, Paulson on bottom again. 28 January 2013.2 Bloomberg Markets Magazine, Narula’s No. 1 Hedge Fund Gains 38% Betting on Mortgages. 13 January 2013.

7The credit fund opportunity | The new debt investors

Case study 1Intermediate Capital Group: A tailored approach

The mood at Intermediate Capital Group (ICG), the specialist investment firm and asset manager, was upbeat at its recent Christmas party, according to Garland Hansmann, Director and Portfolio Manager at ICG. At EUR2.5 billion, it had just raised the largest ever European fund.

This is the latest fund dedicated to filling the lending gap for European mid-market companies that would have relied on banks in the past but now go first to other specialist lenders.

ICG can trace its history back to 1989 when it led a mezzanine bond buyout of a French fire extinguisher manufacturer. It floated on the London Stock Exchange in 1994. Fast-forward 18 years: it now manages more than EUR12 billion and has become a key thought leader in European debt investing.

Hansmann says: “The new mezzanine fund has proven attractive. Investors have come from all over the world, but the firm is particularly pleased with the substantial interest to have emerged from the United States. Companies are today looking for very specific solutions to address their financing needs. They want to find partners who can bring a tailored approach and move quickly. We can.”

ICG presented the following narrative to potential investors: Europe is going to need a long time to recover during which inflation and interest rates will stay low. There is a lack of debt and low buyout deal volumes at the very moment when refinancing issues are high and there is no shortage of strong, recovering European businesses needing financial support.

ICG’s management have been consistent in pointing out to the market that there were no shortages of loans signed in 2007 and 2008 that are now in the process of coming up for re-negotiation. This is just one smaller element of where the wall of demand from the corporates for non-bank finance is coming from.

The new fund has already made four investments. One of these was the backing of Esmalglass Itaca of Spain. This business had been bought out by 3i in a EUR230 million deal in 2002. Ten years later 3i wanted to exit and found another buyout firm – Investcorp – to buy the business. Yet, the lending market in Spain was shut.

Investcorp needed support from a debt investor to help it complete the deal. ICG provided a EUR105 million senior loan note and also invested EUR6.6 million in the equity of the business. In another era, this would have been fought over by countless banks to deliver the opportunity.

ICG has characterised three trends behind this latest clutch of deals. These are:

1. Sponsored mezzanine deals when a business is backed by a traditional private equity investor and ICG is invited to provide mezzanine funding.

2. Sponsorless transactions when ICG is leading the investment with a blend of capital.

3. Stressed sellers who are keen to find a strong vendor with the ability to complete quickly.

The firm expects to invest this fund in less than two years.

Meanwhile, ICG has new strategies to take advantage of these live opportunities. In September 2012 it launched a new strategy, Total Credit Fund, which has a core investment of senior secured loans and high-yield bonds and will also invest opportunistically in collateralised loan obligation debt and European stressed credit.

Hansmann says: “Companies that issue loans are the same companies issuing bonds. Why shouldn’t an investor be able to access both from the same fund?”

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Case study 2Park Square Capital: Dramatic dislocation in European credit markets

Robin Doumar, Managing Partner of Park Square Capital, is meticulous with his words. He says: “Commentators use the word disintermediation for what is going on with the banks and the debt markets. This is more of a gradual, organic process. What is happening is much more dramatic than that. It is a dislocation.”

The founder of the credit investor and adviser with USD3 billion of funds under management is today seizing the opportunity. Much of his time is spent explaining what is happening in Europe to LP investors from all over the world, who are seeking clarity on how they can best navigate these markets, to source investment opportunities in 2013 and beyond.

The fact that banks have scaled back/stopped may stir the interest of LP investors, but there is still a huge effort required to source and complete the deals to ensure they are generating the returns they want.

Doumar, ever conscious of the need to be exact, says: “When we see the LPs, we do not use the language of shadow banking. That sounds murky. What is happening is an institutionalisation of the European loan market.”

He points out that Europe used to be a bank market as they held two-thirds of corporate loans with the residual third held by institutional investors. That is undergoing significant change and there are only a small number of specialist investors with the proven track record to manage this opportunity.

Park Square Capital was founded in 2004. It uses what it calls patient fund structures complemented by deep levels of in-house credit analysis to invest. It has built a particular reputation investing in the debt portions of various private equity transactions, backing 42 transactions to date.

Doumar says: “In 2007 there were 200 investors in the European loan markets. Of these one-third might have been able to write a EUR50 million investment in a deal. Today there are fewer than ten firms who can invest more than EUR50 million in a transaction. That shows how the market has changed.”

This dislocation is unlikely to be fixed soon. Doumar believes it may take as long as ten years for the full process of institutionalisation to take place. He says: “Look at the US market. There the banks account for a maximum of 25% of the market. Other institutional investors account for the remaining three-quarters. That process needs to happen in Europe.”

9The credit fund opportunity | Operational challenges and solutions

The lack of infrastructure is probably the biggest adjustment for credit hedge fund operators.

“It’s not becoming simplified,” explains Andrew Mulley, Head of Issuer Services, Citi Securities and Fund Services EMEA. “It’s becoming complex to get to a simplified position.”

Investing in this market is a much more complex undertaking than buying a conventional security, particularly in Europe. Investors must cope with a variety of risks, both familiar and unfamiliar. Managing this type of transaction is markedly different and more operationally cumbersome than other asset classes.

“When you’re buying syndicated loans or you’re buying whole loans for mortgages, you’re actually buying contracts with the buyer,” says Citi’s Salvage. “It’s not as simple as doing a delivery versus payment. You actually have to find a way to hold the legal title to those assets.” For a syndicated loan, he says, closing and legal review can take as long as a week.

Although terms tend to be more negotiable, the lack of standardisation also makes loans more complex to work out. “It’s important for an alternative investor in this market to understand and have experience in the middle and back office side of administering credit, because if you don’t get that right, that’s where mistakes can happen,” advises Tyndaris’ Steven Edwards.

Securing Another major operational challenge is verifying the position. Securities are easy to safe keep as you just hire a custodian or a broker. By comparison, with direct loans the only other party who knows you have the asset is the one responsible for paying the cash flows on it.

To manage this firms need a specialised settlement department or loan-closing team that is familiar with legal documentation. They also require an administrator or custodian who is capable of validating the position exists.

Risk and pricingUnderstanding credit risk and being able to price it is of course an essential skill. However, pricing becomes complicated when a market is illiquid as appropriate benchmarks and comparables are not always easy to find. Product transparency seems likely to help.

Benefits of this new market include:

• Covenants tend to be more favourable to lenders in the loan market than bond covenants.

• Insight into the borrower’s business can also be much greater than in the bond market, where the investor gets a view into performance only once a quarter. “We are able to get private access on an ongoing basis,” says Bowers.

TransparencySince 2008, lenders have focused on improving transparency as a way to regain the confidence of the market. “Once you get transparency, transparency leads to confidence and confidence leads to investors re-engaging their cash,” explains Mulley.

Fund managers need to be prepared for a lot of questions on transparency.

“Debt funds are increasingly requesting monthly reporting and sometimes an estimate of a partner’s monthly capital balance. On a quarterly basis, clients require a much more detailed report that goes out to the investor that lists every debt position that the fund owns. That includes duration, coupon rates, information on the hedging activities that the fund has taken, if any, and whether they’re hedging out their currency exposure or some of their interest rate risk,” says Salvage.

This is especially useful for insurance industry investors as Solvency II does not mandate higher capital reserves, as Basel III does, but it does ask for higher credit quality and more granular information.

Operational challenges and solutions The discussion around disintermediation tends to focus on the simplicity of a direct interaction between buyer and lender. In fact, the concept in most instances is less than simple. Professionals in the market say the execution of non-bank loans tends to be much more difficult to achieve, particularly in Europe.

The lack of infrastructure is probably the biggest adjustment for hedge fund operators.

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It is especially important that this system is set up right from the start of the deal. For instance, it is worth asking a prospective administrator how the data about the loan is received and entered into the computer. A manual rather than an optical process for data entry could be prone to error. “Data quality is everything, particularly for closed-end funds. If you get that data wrong at the start, it’s wrong all the way through,” says Kamran Anwar, Head of Private Equity Services EMEA, Citi Securities and Fund Services.

SimplicityFor similar reasons, investors are shying away from complex structures with many endeavouring to be overtly simple in terms of trenching their subordinate and senior positions.

Even so, lack of clarity remains a problem. Often, according to Anwar, the things that go wrong with a loan are the result of a lack of precision in the original legal agreement rather than a glaring omission. “I haven’t seen anything go terribly wrong, but I have seen the legal documents of the funds not being clear enough, leaving parts of the waterfall or parts of the management fee calculation up to interpretation,” he says.

Income generation can lead to the creation of more complicated structures to optimise a firms’ tax treatment in various different jurisdictions, depending on what the trading strategy is. One example is where an investor must pay a tax bill on income earned but never received e.g. proceeds locked within a private equity fund.

ServicingAlthough bank loans are similar in many respects to traditional fixed income securities, borrowers utilise the loan market for a reason: to preserve the flexibility of a true credit agreement that can be amended on a bilateral basis versus a bond that is restricted by its covenants. This does mean an element of complexity will always remain.

• Subservicing. Investors must ask their manager how the subservicing is handled. Bank loan servicing norms can differ from country to country in Europe, and an experienced servicer with knowledge of multiple markets will provide consistency and accuracy.

• Tax. All firms must file tax documentation. It’s important the provider can see a set of books for each entity and understand how much income was generated on a book. This allows them to report effectively.

• Currency. This is especially important for long-running investments. For instance, one fund Citi’s team worked with recently had both euro and sterling commitments, and they found that, because of the differential in strength between the currencies, the pound investors would end up with a disproportionate percentage of the assets over time. Any FX gains and losses would also need to be uniquely allocated to the pound or euro investors.

• Partner. Managers say banks are likely to play an outsize role as providers of intermediary services, particularly the largest money-centre banks. “I think there are a limited number of banks, Citi among them, that have the global reach and the talent to find structures to attract new capital to the commercial real estate sector in Europe,” says Tyndaris’ Edwards.

Bank loan investing: an integrated servicing view

Bank loan activities

Syndicated, club and bilateral loans, par and distressed debt term, delayed draw, revolving debt, DIP, first lien, second lien,

distressed, middle market, LOCs

Client portfolio

Portfolio and product support

Loan administration and custody

Loan origination

Integrated operations, service and data management

11The credit fund opportunity | Intermediaries: their role

Today, banks and other intermediaries are fulfilling an important role in helping investors find loan pools with the right characteristics to meet the needs of their portfolio and in managing and monitoring those loans as long as they hold the investment.

The new asset class raises important “question marks around who is servicing the assets and what is driving performance,” says Mulley.

Even so, Edwards sees a long road ahead. “It’s going to be challenging because of regulatory issues as well as real estate market and political issues in Europe. However, it’s those solutions that will ultimately bring liquidity back.”

Intermediaries: their roleProspective investors in Europe’s new debt market are looking for a partner who is more knowledgeable, has more infrastructure and can assist them as they enter the market.

Today, banks and other institutions are fulfilling an important role in helping investors find loan pools with the right characteristics.

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1. Find the right adviceDebt is a complex asset class. Hiring the right expertise is paramount. “You’ll want to look at the specific capabilities of the individuals and the track record of their products,” says Citi’s Anwar. “You hire people from the market who have done it before. You look for specific knowledge and experience.”

What kind of manager will do well in this space? “Those that have an ability to evaluate and price credit risk across a variety of domiciles and sectors should do well,” says Anwar. Especially useful, he adds, are managers who understand both private equity and hedge structures. Co-mingling of these structures maybe simple in concept but highly complex in practise. Engaging your experts early in the process and soliciting active feedback is critical.

2. Get ready for a different pace Loan origination and loan sales are much more complicated than buying a conventional security. “You need to be ready to handle the paperwork involved, and have either dedicated in-house legal support or a trusted adviser who can handle the administrative issue – or both,” says Citi’s Salvage. Even investors experienced with non-bank lending in North America are likely to find a very different experience. For example, where

settlement time is typically within seven days in the US, in Europe it can take place up to 30 days after the trade date.

3. Prepare for tax complexity The tax administration requirements that go along with debt funds may be much more complex than anything most investors will have dealt with before. For instance, some of this can be headed off by structuring deals from the beginning with the correct tax treaty access in mind.

4. Think long-termThe full value of this opportunity may be next year or nine years from now. Past experience in watching deleveraging occur in Japan – and anecdotal evidence that there has not been a spike in foreclosures in Spain because banks are extending their terms – means that investors need to keep their short-term expectations modest. Capital lock-ups of up to five years are not uncommon.

5. Look outsideOne of the key lessons of the last crash was the degree to which externalities affected performance. Correlations between asset classes and markets, the strength of the counterparty of hedges and election cycles can all have an impact on the success of an investment.

Five tips for successful debt investingWhile there are many things to consider when investing in debt, some of best practices proposed by those interviewed for this paper are detailed below.

• Regionally experienced talent in-house – investment, legal…

• Portfolio and process transparency across the loan and investment lifecycle

• In-house resources Operational risk – Efficiency and accuracy

• Data access and reporting

• Resource management

• Niche environment

• Highly complex process requires specialised expertise and dedicated resources

• Operationally intensive processes push the limits of in-house capabilities and infrastructure

• Objective review of existing processes – move to automation

Debt operations — key considerations

Key operational features of the market

Manager considerations and concerns

13The credit fund opportunity | Making a success of new opportunities

Like any new market development, there is inherent risk and opportunity. There are also outside factors to consider such as new regulation. But, perhaps the largest question mark is around the timeline: just how long will disintermediation take? “I think it’s happening slower than it should or than anyone could have expected,” notes Daniel Gissendanner, Managing Director, Head of Leveraged Credit Sales, Citi Capital Markets Limited.

“We know from our own experience that banks have been quite constructive in the non-investment grade space.” he adds. “We’re seeing more scrutiny, but not complete withdrawal of those banks [from the loan markets].”

Making a success of new opportunities“Shadow banking services enable greater financial system interconnectedness, which helps reduce idiosyncratic risk through diversification but also exposes the system to spillovers in the event of large shocks” (International Monetary Fund).8

Sooner or later, says Citi’s King, the disintermediation is going to happen: “It’s clearly happening, it’s just a question of speed.”

Like many alternative investments, non-bank lending is operationally complex. Many market-watchers believe some of this will be smoothed over as the market matures.

For investors, all these moving parts will be important to understand. The nature of this asset class demands extensive due diligence, the right expertise, and deep connections with the market and its players.

If investors have learned anything in the past five years, it is that confidence counts. Returns matter, but what matters more to the holder of any security is confidence in their understanding of how those returns are generated, and perhaps most of all, confidence in the strength and rectitude of the administrative infrastructure that supports it.

8 IMF Staff Discussion Note, December 2012: Shadow Banking: Economics and Policy, page 27.

The nature of this asset class demands extensive due diligence, the right expertise, and deep connections with the market and its players.

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Guest

Jonathan BowersSenior Managing Director and Senior Portfolio ManagerCVC Credit Partners

Formerly CVC Cordatus, CVC Credit Partners manages USD8.1bn in assets across 28 vehicles in the US and Europe across CLOs, credit opportunities and managed account strategies.

Jonathan founded CVC Cordatus in 2006 and joined from the European Leveraged Finance group at Deutsche Bank (Bankers Trust) where he was a senior director originating and structured numerous financings for leveraged buyouts.

Prior to this, Jonathan worked in M&A at Charterhouse Bank after completing the Citibank Analyst Programme in London and New York. Jonathan holds an MA in French and History from the University of Oxford.

Jonathan ButlerHead of European Leveraged FinancePramerica

Jonathan is Managing Director and Head of European Leverage Finance at Pramerica Investment Management Limited, based in London. He has been instrumental in the development and growth of our European credit business since joining the team in 2005.

Previously, Jonathan worked for NIBC where he invested in senior and mezzanine loans for financial sponsor transactions (leveraged buyouts). He was also responsible for establishing and managing NIBC’s third-party CLO asset management franchise.

Jonathan has held investment positions with Chemical Bank (now JPMorgan Chase & Co.), where he originally received his credit training, and Industrial Bank of Japan (now Mizuho). He received a BA (Hons) in Financial Services from Bournemouth University, UK.

Steven EdwardsPartnerTyndaris LLP

Steven is a founding partner of Tyndaris and Co-Head of CRE credit lending and investing for the firm. He has over 24 years’ experience in CRE lending and investing, CMBS, CRE distressed debt, and direct equity investment and asset management.

He has been active in European real estate since 2001 and played a leading role at Citi’s European CRE finance group, responsible for non-performing loan portfolio lending and commercial real estate financing. Later he also helped lead the effort to sell down JP Morgan’s USD3 billion European real estate loan exposure.

He joined Tyndaris with Heath Forusz in May 2012 to lead the firm’s entry into alternative credit investing and lending in Europe.

Fiona HagdrupFund ManagerLeveraged Finance GroupM&G Investments

Fiona is a Director and Fund Manager at M&G Investments where she has worked since 2003. She is a Fund Manager in the Leveraged Finance team, which is responsible for some EUR7 billion of European loan investments.

Funds managed by the group include separate accounts and pooled funds for institutional clients, including a EUR1.8 billion senior loan fund, the M&G European Loan Fund, plus several CLOs.

Prior to joining M&G, Fiona was a Corporate Origination Executive at BNP Paribas and SEB.

Fiona is a Chartered Accountant, having qualified with Ernst & Young, with an MA in history from Cambridge University.

ContributorsWe would like to express our sincere gratitude to all our contributors for their invaluable insight.

15The credit fund opportunity | Contributors

Garland HansmannDirector and Portfolio Manager Head of High YieldICG

Garland joined ICG in 2007 from Credit Suisse Asset Management (CSAM), where he was European Head of Credit Research and managed the company’s high yield portfolio.

During his time with CSAM, Garland worked in London and Frankfurt. He has also worked as a portfolio manager for Delbrueck Asset Management, managing government and corporate bonds.

Robin DoumarManaging PartnerPark Square Capital

Park Square Capital is a leading independent provider of credit products in Europe, managing and advising approximately USD3.0 billion of capital.

Prior to founding Park Square, Robin spent 15 years at Goldman Sachs in New York and London, where he was the Head of Workouts and Restructurings, Head of European Leveraged Finance and Head of European Mezzanine in the Principal Investment Area.

Robin received his AB from Brown University, and a JD and MBA from the University of Virginia.

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Citi

Kamran AnwarEMEA Head of Private Equity ServicesCiti Securities and Fund Services

Kamran joined Citi in 1993 in Salomon Brothers’ Investment Banking division in New York, where he focused on mergers and acquisitions deals for large-cap companies.

He has since worked in a variety of products and regions including South Asia, the Middle East and Europe. He was the M&A Advisory Head for the Middle East based in Dubai, where he worked closely with a number of regional governments on deregulation and private sector participation, including leading some notable privatisation deals in the Levant and Pakistan.

Kamran has worked closely with several private equity firms across the EMEA region. He has also held senior positions in corporate finance, strategy and cash management.

Daniel GissendannerManaging DirectorHead of Leveraged Credit SalesCiti Capital Markets Limited

Daniel is a Managing Director in Credit Sales with more than eight years’ experience in selling leveraged loans, mezzanine, high-yield bonds and CDSs.

Daniel’s client base includes some of the largest credit-focused hedge funds in Europe, and many of the top-tier CLO managers.

Prior to joining the Sales desk, Daniel spent five years in credit origination, also with Citi, primarily in the TMT sector.

Andrew MulleyManaging DirectorEMEA Head of Issuer ServicesCiti Securities and Fund Services

Andrew has worked in the banking industry for over 20 years, specialising in corporate trust, collateral management and structured finance.

He was involved with the establishment of the first European corporate trust office for an American bank in the early 1990s before developing a successful collateral and structured finance services business in Europe and Asia and working to launch Citi’s Middle East Issuer Services business.

Andrew has been involved with some of the earliest structured finance transactions in Europe and Asia, delivering transaction solutions to a range of asset classes and structures.

He spent 10 years in Hong Kong and Japan in the industry, working on both the trustee, services and arranging sides of the business.

Joseph PatellaroManaging Director Global Head of Citi Private Equity Services Citi Securities and Fund Services

Joe is responsible for the global strategy and evolution of the Private Equity Services business, and interacts with many internal and external constituents worldwide, staying current on industry, technical and regulatory matters. Joe has led or participated in many industry-related conferences, panels and events on topics including the evolving regulatory landscape, fair value/ASC 820, outsourcing and more.

17The way we lend now | Contributors

Joe has been in the professional services industry since 1987, and has been with Citi since 2002. Prior to joining Citi, Joe spent over 15 years at Arthur Andersen, most recently as an audit partner and the partner-in-charge of the emerging markets practice in the Stamford, Connecticut, office.

Joe is a graduate of Hofstra University. He proudly serves on the Board of Trustees of Family and Children’s Association, a Long Island-based non-profit organisation.

John ReidyDirectorAlternative Investments Client & Sales ManagementCiti Securities and Fund Services

John joined Citi in 2010 and is a Director of Client Sales Management in Citi Securities and Fund Services with a primary focus on alternative investments.

Prior to joining Citi, he was the Chief Executive Officer of the HFX Capital Corporation from 2008 to 2010.

Before HFX Capital, he was with State Street and Investors Bank & Trust, where he spearheaded the growth of Investors in Europe to EUR375 billion in assets serviced. John was a Senior Director and Head of Business Development outside the US. John joined Investors in 1999 (subsequently State Street Corporation from July 2007) as a Director and Head of Client Management in Europe.

John has over thirty years of financial services experience, covering alternative investments, investment management, and custody and administration.

Peter SalvageManaging DirectorEMEA Head of Alternative InvestmentsCiti Securities and Fund Services

Peter is a Managing Director and the Head of Citi Alternative Investment Services for EMEA.

He is also globally responsible for middle- and back-office services to single manager hedge funds. Hedge fund managers use these services to reduce operational complexity and risk, allowing them to focus more on investment decision-making.

Prior to Citi, he was with JP Morgan Hedge Fund Services, where he served as the Global Product Head for services to single manager hedge funds.

Prior to JP Morgan, Peter was a corporate banker with Citi’s technology industry banking group.

He spent the first part of his career as a news journalist based in London, Berlin and Brussels.

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Notes

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