But the real saving for some allocators can be measured in terms of the internal resources needed to source, due diligence and monitor funds, and handle administration. BNPP CP has teams to carry out extensive on-site due diligence, with very detailed reports and internal scoring for investment and operational risks in each selected fund. Investors could also receive as much communication and transparency as if they invested directly: sight of underlying funds’ positions and receive quarterly reporting, commenting on deal flow, events, portfolio allocations, and NAVs. BNPP CP is well placed to cater for insurers, whose solvency Capital Requirements under Solvency II are reduced by reporting each underlying fund’s portfolio through an AMPERE matrix breakdown, supervised by EY. BNPP CP’s experience in private equity fund administration helps with asset/liability management and monitoring cash calls, which are usually synchronised with those from investee funds. Another advantage of a multi-manager model for drawdown fund structures is netting: where distributions from underlying funds can be offset against capital calls this may reduce or relieve investors’ need to stump up cash during some periods. ESO is a closed-end fund structure, and a Luxembourg RAIF (Reserved Alternative Investment Fund).

Double digit return targets

Returns, measured by internal rate of return (IRR), on the relevant part of the existing mandate, have been in the mid-teens since 2013. The new vehicle has a somewhat lower target of a net 9-12% IRR, because – absent a sharp rout in credit markets – “current vintages are probably not going to be as juicy as they were five years ago,” says co-CIO, Thierry de Rycke, who co-manages the strategy with Giuliano Rajabally.

Still, this return target is well above liquid credit and part of the anticipated return premium can be seen as an illiquidity premium that can be exploited by funds with locked up capital. It is also a complexity premium. Returns should also be boosted by the fact that some sellers of the target assets are forced or stressed sellers, and there is not always much, if any, competition from buyers: these assets often need to be accessed bilaterally rather than being auctioned publicly or traded on secondary markets. The volume of capital chasing opportunities in Europe is still relatively small: judging by the top 100 private debt managers, whereas US funds have raised USD 502 billion over the past decade, those in Europe have only gathered USD 103 billion, according to Preqin.

IRRs will clearly depend on how long it takes to monetise assets. For instance, if non-performing loans can be sold rapidly at a profit the IRR could turn out to be higher than where a foreclosure and court process is needed. De Rycke reckons: “the target could prove to be conservative. We would rather under-promise and over-deliver”. The return drivers arguably reflect the novelty of the asset class: private debt funds did not really exist before 2008, according to Guerin.

If the credit cycle does turn south, managers would then be more likely to take advantage of secondary market upsets – and returns could be higher. BNPP CP has no house view on the credit cycle, but underlying managers have some degree of optionality to take advantage of dislocations. The weighted average life of underlying portfolio assets is expected to be around two years, so managers could redeploy capital into higher yielding opportunities.

Northern and Southern Europe

European banks still need to dispose of EUR 2.1 trillion of non-core assets, and sold EUR 144 billion in 2017, according to PwC and Deloitte. A whole host of new regulations may accelerate the pace of disposals: EBA stress tests; the Asset Quality Review in 2014; bail-in bank resolution rules and the fourth phase of Basel III from 2016; the ECB’s stipulations on NPL disposals; and accounting standard IFRS 9 forcing sooner recognition of impairment, all turn up the heat on banks. Other factors that encourage deleveraging include the absence of out of court restructuring, and the political sensitivity of foreclosure in some countries.

Little wonder, then, that European bank lending has shrunk by about EUR 500 billion since 2008, and only part of the gap has been filled by leveraged loans.

This ongoing saga of European bank deleveraging has created two broad categories of opportunities in Europe’s highly heterogeneous banking market, where the percentage of non-performing loans ranges from 0.8% in Luxembourg to 45.3% in Greece.

Structural and tactical opportunities

“In Northern Europe, banks have generally completed their deleveraging but structural or strategic gaps in the market exist because they have not reverted to providing credit for certain market segments, such as smaller and medium-sized, mid-market, enterprises or stressed and distressed borrowers,” says Guerin.

“In contrast,” he points out, “the pace of deleveraging in Southern Europe is now accelerating, which throws up tactical opportunities to acquire assets from forced and stressed sellers.”

The team can allocate to managers investing in most European countries, so long as target returns match expected risks. In the most creditor friendly countries, such as the UK, Ireland, the Netherlands, Sweden and Denmark, the IRR target might be 10-12%. Returns of 15% might be sought from Italy, Spain or Portugal where legal reforms have improved the opportunity set. For instance, in Italy several laws passed between 2014 and 2016 have removed legal obstacles to foreclosure, expedited bankruptcy processes, and reduced stamp duties. Greece is currently off limits due to a dysfunctional legal system that has let borrowers delay foreclosure for decades.

In between these extremes, France and Germany are becoming more creditor-friendly thanks to new laws around restructurings. The strategy might exceptionally take advantage of opportunities in the US. It is very unlikely to invest in emerging markets, with the possible exception of Central and Eastern Europe, where legal changes in countries such as Poland are giving creditors more power to appropriate assets. Significantly, the highest IRR targets reviewed by the team, of 18-20%, relate to a fund in Poland.

Senior and secured

In today’s credit markets where liquid paper often trades above par, and 74% of recent European loan issuance was covenant-lite, the ideal trade for ESO managers involves paper at a discount to par and intrinsic value, in creditor-friendly jurisdictions, and with tangible collateral and strong, often negotiated, covenants – and a foreseeable route to recovery.

The aim is to acquire loans close to liquidation value. The avenues for monetising them could fork. Managers might offer borrowers the chance to repay the loan bought at say 40 cents for say 60 cents, or threaten to go through a legal process to foreclose on and sell assets.

“In most cases, the collateral underlying loans will be senior and secured, and it is usually commercial property. Commercial real estate is a very situation-specific market. It could include infrastructure such as toll roads, renewable generation, train stations or data centres,” says Guerin.

The mandate of the fund leaves open the possibility of being exposed to unsecured debt, but, “this will be a smaller sleeve and is only likely in situations where lenders have recourse to a first lien over other assets of the borrower,” he continues.

Special situations

“Special situations corporate or SME bonds or loans are likely to make up 50-70% of the allocation, and will be found in countries where structural gaps exist, and often in niches where direct lenders are not active because deal sizes are too small. These can include distressed, stressed and restructuring situations, often in specific regions or industries,” Guerin adds.

Stressed paper might trade at 75-90 cents while distressed could go as low as 40-60 cents on the dollar. Restructurings could be organisational, operational or financial. As with the senior, secured debt, the paper should be first lien. Where paper has a coupon, it is usually floating rate.

Sometimes there is an equity kicker, which is nearly always private equity because smaller companies are much less likely to have a public listing.

“Mezzanine, venture debt and trade claims could be pursued at the margin but are not likely to be core allocations,” says de Rycke.

Niche, specialist funds

Globally 422 private debt funds exist, according to Preqin’s September 2018 survey, but only about one or two percent of the universe is likely to be invested in by ESO. “The plan is to allocate to between four and eight managers, which will take about two years. In any given year, 30 to 50 private debt managers are in fundraising mode, of which three or four are likely to meet our criteria. This defines the hard capacity constraint of perhaps EUR 300 or EUR 350 million (which also takes account of the deployment needs of the existing, evergreen mandate). Some private debt managers clearly are raising billions in a single fund but this would not suit our focus. To raise more assets would risk diluting the opportunity and reducing the return target perhaps down to 8-10%, as it would have to be invested into larger funds active in less interesting areas,” says Guerin.

The preference is for funds managing between EUR 200 million and EUR 1.5 billion; firm assets across several vintages may be higher. None of the short-listed managers belong to Preqin’s rankings of the world’s largest fifty private debt managers, and very few are even in the next fifty. This is partly just because over two thirds of the biggest 100 managers are in the US, and others do direct lending, but is also a deliberate policy to add more value for clients. “Clients are not paying us to screen the top 100 managers they can easily access anyway. Clients use us to source niche managers, and share in our transparent due diligence. If managers grow assets enough to join the top 100, they will probably fall off our radar,” says de Rycke. Chosen managers are sourcing deal-flow that may be off the radar screen of larger managers, since loans worth tens of millions will not really move the needle of returns for multi-billion funds.

BNPP CP often has a preference for country or region-specific funds, with local presence on the ground to source deal-flow by cherry-picking individual loans rather than buying whole portfolios. The need for networks to source deal-flow via local offices from banks, companies and sponsors can create barriers to entry. ESO looks for expertise in structuring bespoke deals and sometimes also in restructuring.

In the investment universe, roughly half of shortlisted funds are run by hedge fund managers and the other half by private equity or dedicated private debt managers. Management fees range between 0.8% and 1.5%, while performance fees are nearly always 20%, above an 8% hurdle rate. This means that investors need to receive an IRR of at least 8% before the manager gets a performance fee, which will only be paid on realised returns at the fund level. Deal-by-deal carry structures are now very rare. Prior to realisation, valuation is nearly always mark-to-model, meaning these funds are virtually all comprised of level 3 assets (currency hedges where they exist are generally the only level 2 asset).

ESO does not envisage allocating to affiliated funds. BNPP CP advises BNP Paribas Asset Management (BNPP AM) on its seeding and incubation program, but BNPP AM has not incubated any private debt funds so far and has none in the pipeline. If BNPP CP were to ever allocate to fund incubated by BNPP AM, the seeder economics would be carved out to mitigate potential conflicts of interest,” clarifies Guerin.

Capital could possibly be raised from or via other parts of BNP however. “BNPP CP is wholly owned by but is separate from its corporate parent, BNP Paribas. BNPP CP benefits in three main ways: as a holding company, potential distributor and client,” says Guerin.

Due diligence

The DD process typically takes three to six months. BNPP CP’s 35 staff include eleven investment professionals in the Absolute Return and Alternative Solutions team. A dedicated team of two full time IDD and three full time ODD professionals do the bulk of the work, which includes quantitative filtering, performance and peer group analysis, reference-taking, calls, site visits, and a full review of legal documents, standards of practice, AIMA questionnaires, and governance. A dedicated risk controller reports directly to BNP Asset Management and can veto investments, as can the ODD team.

Over the past decade, most asset classes in the US have generated better returns than in Europe but that has not always been the case. With surveys suggesting that European private debt now is a top pick for more investors than is US private debt, the timing of the ESO roll out seems opportune.