Understanding the changing landscape of European debt funds
Under the spotlight of Navigating Structural Shifts, INREV spoke with the Debt Funds Committee Chair and Vice-Chair, Isabelle Brennan, Senior Managing Director (Credit and Global Solutions) at LaSalle Investment Management, and Mohamed Ali, Director in the Strategic Insights and Research team at Nuveen Real Estate to discuss the recent evolution of European real estate debt funds and how investors can navigate these changes.
Post 2020, falling real estate values created substantial refinancing needs, with debt funds playing an important role. ‘Both insurance organisations and debt funds contributed in different ways,’ explains Isabelle. ‘Insurance largely provided bulk capital while debt funds were willing to lend at higher LTVs. A number of insurance and debt fund tie-ups also took place.’
Mohamed sees these developments as just the latest chapter in the longer-term maturing of the debt fund investment landscape. ‘Europe has moved closer to the US model over the last 20 years, accelerating in the last five. The banks dominated lending previously, but now there is more balance between bank, insurance and debt fund lenders across the continent.’
One of the most talked-about trends among European debt funds over recent years has been the rise of ‘back leverage,’ where banks lend to debt funds in order to improve returns. ‘This has happened largely due to the transition in banks’ role in the market, which has come partly as a response to the latest Basel regulations,’ says Isabelle. ‘It’s now more beneficial for banks to lend through funds rather than directly. In turn, this has allowed debt funds to deliver higher returns to their investors. There’s an additional element of risk to the vehicle, but no more than for an unlevered fund ultimately. Senior debt is now playing a bigger role relative to mezzanine than in the past.’
'Investors can now select the right fit for what they're trying to achieve in their portfolio.'
Mohamed sees this trend in terms of banks’ shifting towards the more senior end of the lending spectrum, while non-banks have been taking on whole loan strategies to fill the gap they have left. ‘But having banks re-enter the whole loan space via back leverage effectively leaves the risk level for debt funds the same as for whole loan lending in the past, albeit there are two lenders involved rather than one in the capital structure. As long as it is structured properly, the debt fund should be in control.’
The example of the growing use of back leverage highlights the increasing complexity of the debt fund marketplace, which has developed alongside a wider investor base and the broader range of strategies it can potentially support. ‘There have been more investor types who might look at this kind of investment,’ notes Isabelle. ‘For many years, there were insurance and pensions clients, but now private credit, family office and retail money is flowing into this space as well. Investors are getting more sophisticated at comparing risk adjusted returns across strategies and asset classes, with a growing range of debt fund structures available to meet different objectives.’
‘Traditionally, real estate debt fund has appealed to investors seeking downside protection, stable income and lower volatility,’ she continues. ‘But now with the huge variety of structures that are available to investors, we're seeing players across the full risk and return spectrum. Investors can now select the right fit for what they're trying to achieve in their portfolio.’
However, with this increasing flexibility also comes greater complexity, which puts a premium on market education and understanding, something that INREV is looking to bolster. At the same time, there is a growing need to be able to compare risk/return outcomes as the number of vehicles and the size of the investable universe expands.
‘This is probably the best time in a decade to enter the asset class.'
Isabelle explains that one of the goals of INREV’s Debt Funds Committee, which she chairs, is to demystify some of these areas. ‘There's a lot of data out there, but not much is standardised. Things can be misinterpreted. One of our main goals is to help investors sift through all the information and get to the crux of what risk is being taken. How should they think about it? What should they compare between things?’ Some of these questions have been addressed in our new paper: “Baker’s dozen” - Key 13 questions to understand the risk of investing in real estate debt funds.
This is also one of INREV’s main reasons for developing a debt funds index, preparations for which are now gathering momentum. ‘We are at the start of a complex process,’ she says. ‘One of our first goals is to agree on a set of standardised data disclosures by managers. We want as many managers as possible to participate because the more data you have, the more you can slice and dice into segments that are not identifiable. We've certainly got buy-in from investors, but now we need all the managers to understand how potentially beneficial this could be for them.’
Mohamed, who is the Vice-Chair of the committee, adds that every manager wants to have an index to compare themselves to, because investors are all asking for this. However, sufficient trust needs to be gained to make this happen. Nevertheless, both he and Isabelle agree that the prospect of better information is one of the encouraging signs for the future development of the debt fund sector, which looks well placed to make further progress among investors in the medium term.
‘This is probably the best time in a decade to enter the asset class,’ says Mohamed. ‘Asset values have been re-based, and lenders generally have a good equity cushion. At the same time, margins are relatively elevated due to ongoing market uncertainty. And the equity side is starved for capital because people are uncertain about the market. If you are able to deploy debt, it is a really good time to be doing that right now.’
Isabelle agrees that in times of uncertainty, people tend to move towards lower-risk positions. ‘Having the equity cushion that comes from being in a safer part of the capital structure, whilst also being able to capture attractive risk-adjusted returns, is something that investors are inevitably seeing as beneficial.’
If you’re interested in more debt funds-related resources, view our dedicated page on this topic or subscribe to our current spotlight ‘Navigating structural shifts’ to receive updates directly in your inbox.
