Debt funds: Link up or look out

There is no doubt that the European debt market offers an interesting window of opportunity for debt providers in Europe. A significant mismatch looms on the short term as fund managers and other players scramble to put in place new debt vehicles in a bid to provide relief to investors parched by the property financing drought. Looking forward, it is inevitable that Europe will follow in the footsteps of the US debt market where the balance between financing provided by traditional sources and alternative lenders is about equal. In the US about 50% of the debt is provided by banks while the rest is provided by other institutions and alternative lenders. In Europe, as much as 90% of the debt is still provided by the banks.

In due course, the situation in Europe will shift and industry watchers like Rob Wilkinson, chief investment officer AEW Europe, expect the US situation will be replicated here. In the past six to 18 months, there has been a wave of initiatives from new players to the business such as AEW Europe and Henderson Global Investors, but also existing players with experience in the US such as Cornerstone Real Estate Advisors and GE Capital. Nevertheless, it will take time for credible senior lenders to enter the space. As Isabella Scemama, head of commercial real estate finance at AXA Real Estate, pointed out in a recent interview, there is room for small players, but some are underestimating the barriers. Moreover, Europe is not the US: the US has a relatively flexible legal framework for granting mortgage loans through non-bank institutions.

Like its German counterpart Allianz Real Estate, AXA has a first-mover advantage in the senior debt market: the Paris-based investor already launched its debt platform seven years ago and now has the capacity to cherry pick and be very selective. Newcomers by contrast need to evolve quickly to take advantage of the current dry conditions in the financing world. It goes without saying that real estate skills are also a prerequisite, but that alone is not enough. Aside from lending expertise and an understanding of technical issues in the area of tax and legal affairs, critical mass is crucial.
That message emerged loud and clear at Expo Real in Munich. One of the key problems facing alternative lenders in the current market is that they are too fragmented, said Rob Reiskin, co-head of Europe at US investment firm Heitman. During a panel discussion on what institutional investors are looking for in Europe, he urged small players to seek consolidation in order to make the lending market more efficient.

The message was further reinforced in a recent analysis by Swisslake Capital which signals a second wave of debt funds in the first three quarters of 2012. The first wave occurred immediately after the outbreak of the financial crisis as many fund managers were expecting a fire sale of loan portfolios by flailing banks. However, the wave subsided shortly thereafter and the number of new fund launches declined drastically after it became clear that the big sell-off s would not be forthcoming.

This time round, the signs look more promising but Swisslake does have some reservations. In its analysis, it points out that it is premature to ascertain the prospects of fund managers trying to build a business in this new niche segment. Only time will tell if they are able to achieve attractive and sustainable returns when sourcing the right investment opportunities. Swisslake also casts doubts on the potential rating of debt funds: one could argue that it was rating agencies who gave investors some level of comfort to invest in products that were complex and contributed to a large extent to the outbreak of the global financial crisis.

The facts all point in one direction: investors considering this new niche market would do well to follow the players with a proven track record.