06 May 2024
With many European SMEs choosing to stay private for longer – and, in some cases, reversing their publicly listed status altogether – we believe European private corporate credit plays a fundamental role in supporting their growth, especially amidst an ongoing reduction in bank lending. The introduction of regulated frameworks, such as ELTIFs, means a broader investor base can now gain early-stage access to alternative assets such as private credit. The European private credit market presents an opportunity for investors to take advantage of potentially higher returns compared to the US market, as well as certain defensive characteristics that can help ride out any volatility on the horizon, in our view.
The vast majority of businesses within the European Union are small and medium-sized enterprises1. This means that long-term and sustainable economic growth in the bloc is contingent on supporting these companies, especially as many of them are increasingly choosing to stay private for longer2.
As bank lending in Europe continues to retrench due to ever more regulatory requirements3, the business ecosystem is primed for private lenders to step in and help drive Europe’s economic engine, in our view. We believe private debt can play a fundamental role in financing European SMEs through their growth cycle, but how can investors access this exciting landscape?
In order to tackle the public funding gap for private companies, the European Long-Term Investment Fund was introduced in the EU in 2015 to encourage investment in Europe’s real economy. The objective was channeling capital towards core areas such as corporates, infrastructure, real estate and sustainable investments, while advancing the democratisation of private assets for retail investors4.
In the past, many European retail investors struggled to gain exposure to the unlisted, long-term investments that ELTIFs typically hold. Private markets – where innovation may be more likely to be driven by smaller companies with new technologies or ideas – have historically been the dominion of institutional investors such as pension funds, endowments and sovereign wealth funds.
“By investing in private credit through ELTIFs, a broader range of investors can potentially benefit from diversification, attractive risk-adjusted returns, and exposure to the financing needs of the real economy.”
The inherent illiquidity of many segments of private asset classes has generally been a barrier to entry as closed-end and illiquid fund structures may not always meet the regulatory or portfolio requirements for certain investor profiles. Managers often demand hefty minimum capital commitments for illiquid private credit assets, which can also impact portfolio diversification for smaller investors.
The introduction of regulated frameworks such as ELTIF 2.0 is driving the creation of a greater number of semi-liquid vehicles that can invest across the private markets spectrum. This ongoing evolution of the alternatives universe has opened the doors for a broader investor base to gain early-stage access to the potential opportunities confined in the space.
The original ELTIF 1.0 framework contained stringent restrictions and definitions on the type of investments that ELTIFs could make. These constraints were designed to ensure that investors were appropriately diversified, but they were seen as too prescriptive limiting the growth potential and leading to a slower initial uptake. But some of these have been revamped and relaxed allowing a broader range of investment strategies and increased investor participation.
“The key benefits of the framework remain unchanged: regulated access to private assets for a broader investor base, and an EU marketing passport which allows efficient access across the region, promoting both investor diversification and efficient portfolio costs,” says Aramide Ogunlana, Private Credit Director at M&G Investments.
Through the ELTIF framework, which was revamped with the introduction of ELTIF 2.0 in January, non-institutional investors can gain exposure to these typically illiquid and long-term investment opportunities that may offer attractive returns over time, in our view. One of the key enhancements was a lowering of the minimum investment threshold of €10,000 to zero, but clients and investment firms must balance access and appetite with ability to deploy in their respective markets. The revamped framework also allows the manager to co-invest alongside their clients, and we believe alignment is a key tool for protecting investor interests, particularly for illiquid long-term investments.
“The modification reducing the minimum investment in eligible assets from 70% to 55%, means public assets can now represent up to 45% of an ELTIF portfolio,” says Ogunlana. “Whilst we welcome a widened definition, the lowering of the minimum allocation to eligible assets means investors must do their due diligence to ensure they are selecting the right fund to bring those private asset diversification benefits to the fore.”
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Source: Citywire Amplify, iCapital and Scope European ELTIF Study 2023.
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Source: Citywire Amplify, iCapital and Scope European ELTIF Study 2023.
Another change is a less restrictive definition of what constitutes a ‘real asset’. Under the original framework, real assets were defined as having a value of at least €10 million. But ELTIF 2.0 defines eligible assets as those that have “an intrinsic value due to their substance and properties”5, which broadens the scope of ELTIF investments considerably.
The ELTIF 2.0 framework provides a regulated structure that enables investors to gain entry to potential opportunities across the broad private credit spectrum. By investing in private credit through ELTIFs, a broader range of investors can potentially benefit from diversification, attractive risk-adjusted returns, and exposure to the financing needs of the real economy.
Under the revamped framework, a semi-liquid fund structure with a multi credit approach can provide access to the broad range of options within the private debt universe – from private corporate lending to real assets lending. These have very different underlying risks and performance drivers allowing flexible exposure to alternative and differentiated types of income-bearing assets across the cycle that can offer potential risk return balancing benefits compared to traditional asset allocation to help ride out possible volatility.
Risk return mapping beyond the 60/40 portfolio
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Source: European Leveraged Loans = CS WELLI, US Leveraged Loans = CS US LLI, European High Yield = HPIC, US High Yield = H0A0, EUR IG = ER00, US IG = C0A0, 60/40 Portfolio = BMADM64E, Global Equities = MSCI World as at 30 December 2023 in EUR terms. Past performance is not an indication of future performance.
Beyond illiquidity, it is important to note that private credit investments carry other inherent risks such as credit risk, liquidity risk, and market risk, which investors should carefully consider before making investment decisions.
Nevertheless, managers with time in the market, such as M&G Investments, are well-placed to leverage their expertise and scale to navigate the often complex world of European private credit, allowing them to flex allocations to capture value across varying market conditions. Companies dynamically change their source of funding, leading to a blurring of the lines as both the liquid and illiquid segments of private credit markets converge. We believe managers with the right skillset are key in order to capitalise on this trend and help investors meet their objectives.
For example, liquid corporate private credit includes broadly syndicated loans that can offer quick deployment, portfolio diversity and liquidity, as well as potential downside protection afforded by security and seniority, with a largely floating rate structure. But some of the best opportunities in private assets are at the higher yielding end of the spectrum on the illiquid side of the market, in our view, such as direct lending to either large cap or mid-market companies where risk is often mispriced. Although liquidity is lower, we believe the inclusion of strong maintenance covenants (largely missing from public markets) may offer investors a risk balancing option whilst maintaining a return premium.
“The fact the US is a larger market goes without saying, but with it being one jurisdiction largely governed by the same regulation, competition is high and we’ve seen a loosening of credit standards to win deals,” says Michael George, Fund Manager at M&G Investments.
“The growth potential is also more apparent in Europe,” he adds. “Banks have largely already retrenched in the US versus Europe which still has significant runway. We also see more tail risks in the US, larger CCC exposure, weaker fundamentals and delivered performance has undershot Europe over multiple time periods, 2023 included.”
European loan market has delivered a consistent premium over multiple cycles
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Whilst the European Union has no business development companies (BDCs), a common means for US wholesale investors to gain exposure to private credit, the introduction of fund regimes like ELTIFs are helping Europe catch up as regulators have taken note of the economic gap that restricting access to private markets creates for both companies and consumers.
As the trend of companies staying private for longer continues, gaining access to European private credit not only provides exposure to all the potential performance benefits that can come with the asset class, but also gives investors the chance to play a vital role in financing economic growth across the European Union while tapping into some of the innovations that could shape society in the future.
1 European Parliament, “Small and medium-sized enterprises”, (europarl.europa.eu), October 2023.
2 Nasdaq August 2022, “As Companies Stay Private Longer, Advisors Need Access to Private Markets”, August 2022.
3 Oliver Wyman, Eurostat, AFME, SIFMA.
4 REGULATION (EU) 2015/ 760 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL - of 29 April 2015 - on European long-term investment funds (europa.eu)
5 Official Journal of the European Union, “Regulation (EU) 2023/606 of the European Parliament and of the Council of 15 March 2023”, (eur-lex.europa.eu), 20 March 2023.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.