The Ascent of Debt Funds
Niall Ferguson writes that money is the source of most progress; the ascent of money has been essential to the ascent of man. “The evolution of credit and debt was as important as any technological innovation in the rise of civilization, from ancient Babylon to present-day Hong Kong.” Banks themselves have evolved since the days of the Medici to "facilitate the movement of money from point A, where it is, to point B, where it is needed," as succinctly put by the 3rd Lord Rothschild. This evolution has recently led to two distinct banking sectors, in Europe and the United States, which are markedly distinct due to the impact of significant differences in regulatory frameworks.
In Europe, banks follow a universal model where loans stay on balance sheets until full repayment, crucially supporting the mortgage loans which make up 44% of EU bank balance sheets. Business loans are predominantly financed by banks due to limited access to capital markets; and European banks use efficient covered bond markets like Pfandbriefe for real estate funding, retaining loans on balance sheets despite a growing loan market for distressed assets. The EU securitisation market, including the UK, is smaller—6% of the US size and 1% of GDP—compared to the US's 18% of GDP according to a recent Oliver Wyman report. A loan servicing industry is developing but is more limited in overall importance. In contrast, US banks can offload loans, reducing balance sheet size but increasing risk by retaining equity and junior tranches in securitisation. European banks' requirements are consistent across large and small institutions, while US regional banks benefit from lower capital requirements.
So which banking model is best adapted to thrive in current conditions? In a recent Financial Times interview, James Gorman, former CEO of Morgan Stanley, highlighted Wall Street's significant growth compared to European banks over the past decade but predicted the gap would narrow. There may be a valid technical trigger for higher European bank valuations which are increasingly returning capital to shareholders, with payout ratios soaring to nearly 80% from 40% since 2021. In 2023, they distributed €121bn in dividends and buybacks, up from €90bn in 2021, buoyed by strong earnings and regulatory approval for reducing share counts. Regulators, historically focused on capital preservation since 2008, now favour buybacks alongside dividends due to banks' resilience in early 2023. Analysts expect European banks, to sustain earnings, meet dividend and buyback targets, and fulfil Gorman's optimistic forecast.
The US model is expected to feel the strain from "higher-for-longer" interest rates, warned Michael Barr, the US Federal Reserve’s vice-chair for supervision. "Managing liquidity risk, interest rate risk and funding costs, I think are going to be challenging," Barr stated. He noted that banks exposed to commercial real estate face risks such as vacancy rates due to persistent remote working trends and property repricing as rates rise.
Moody’s recently placed the ratings of six US regional banks under review for a downgrade, citing their substantial exposure to commercial real estate (CRE) loans. The agency highlighted these banks’ high concentrations in CRE loans, which are facing pressures on asset quality and profitability amid the current higher-for-longer interest rate environment. This scenario has exacerbated existing risks, especially during economic downturns.
According to the International Monetary Fund’s (IMF) semi-annual Global Financial Stability Report published in April, non-performing CRE loans as a percentage of US banks’ portfolios doubled to 0.81% by the end of 2023, compared to the previous year.
As one species declines, others take advantage and as banks adapt to their environment, debt funds are expected to fill the void. Commercial Mortgage Alert’s 13th annual survey of high-yield lenders identified 178 providers of subordinate debt on commercial real estate, including mezzanine loans, B-notes, and preferred equity investments. Of the 111 survey respondents reporting 2023 volumes and 2024 projections, 104 anticipate increasing their lending. This optimism follows continued growth in commercial property refinancings and acquisitions, often requiring subordinate financing alongside senior debt.? Charlie Rose, Global Head of Credit at Invesco Real Estate, noted, “We’re seeing a significant shift towards alternative lenders benefiting from widened spreads and higher rates.”
Non-bank lenders are not expected to replace banks but a partnership model is expected to emerge, with banks supporting other lenders through financing methods. Non-bank lenders are increasingly originating entire debt packages, leveraging bank financing for senior portions and retaining mezzanine tranches. Rose highlighted, “The alternative-lending sector is expanding its market share... those with substantial client bases and strong track records stand to benefit the most.” This shift gives non-bank lenders greater control over borrower relationships and deal structures. As indicated by CBRE's latest Lender Intentions Survey the market is expected to support this evolution with?nearly two-thirds of lenders anticipate boosting origination, driven mainly by refinancing demand. Non-bank lenders, including debt funds, insurance firms, and investment banks, project even higher activity levels (76%) compared to traditional banks (56%).
Arrow Global Group also views private credit and banks as collaborative partners in Europe. Richard Roberts, head of origination and M&A at Arrow Global writes that in Southern Europe, facing financial challenges and balance sheet constraints, private credit provides a viable alternative while maintaining client relationships without burdening banks. In contrast, Northern Europe prioritises cost efficiency and asset management, avoiding intensive sectors like agriculture and small business lending. Private credit, supported by bank wholesale financing, meets niche lending needs. This dynamic is crucial across Europe, with private lenders acting as primary lenders in some regions and supporting banks with overflow lending and distressed assets in others.
KKR foresees significant opportunities for alternative capital providers to finance prime real estate with attractive returns. In 2023, U.S. government agencies, insurance firms, and selected private debt funds met most of the market's financing needs. But intense scrutiny on banks' liquidity and commercial real estate portfolios, especially office spaces, means that banks are unlikely to return to pre-crisis lending levels. If bank lending retreats to 40% of the roughly $5.8 trillion commercial real estate debt market from 50%, a gap exceeding $500 billion opens up. Given current exposures, neither insurance firms nor U.S. government agencies are likely to significantly boost commercial real estate allocations, leaving CMBS and debt funds as potential gap fillers.
Investors sense the growing opportunity evolving in credit. In a recent INREV survey, 84% of respondents plan to increase allocations to European non-listed real estate debt funds for the third consecutive year, reflecting global investors' preference for debt in entering the European real estate market. The expected wave of opportunities generated by a wall of maturing debt has also yet to surface to a meaningful degree for alternative lenders, while signs of distress in the system are virtually absent as traditional lenders play the waiting game and extend existing loans, particularly for well-collateralized debt with strong sponsors
Banks have largely stayed open for business and managers like LaSalleIM are collaborating with them to resolve issues for borrowers, said David White, head of real estate debt strategies at LaSalle in a PERE interview. “We are working alongside senior banks in many instances to find capital solutions, whether that is senior or mezz financing. We are often not there to compete – in many instances it is quite the opposite.”
As lending against real estate becomes less attractive for traditional lenders due to higher capital requirements, banks are becoming more selective and focusing primarily on the assets that make sense for them and where they can add ancillary services or products. While banks have not withdrawn en masse from the syndication market, they are now taking a smaller piece on their balance sheets, says Chstian Janssen, managing director of real estate debt Europe at Nuveen in the same report. “The market segment that works for banks is very efficient and pricing for core assets with low LTVs and a stable cashflow is very competitive. Alternative lenders do not want to compete against banks there; they do not get covered bond treatment, nor do they get to borrow at Euribor plus a small spread. Alternative lenders must find a space where they have a competitive advantage”. While banks remain a formidable participant in the European market relative to the US, where the division between traditional and alternative lenders is more balanced, Janssen is optimistic Europe will move towards a 60:40 split within the next five years. “It is a process of evolution, not revolution,” he says.
Tellingly, Deutsche Pfandbriefbank (PBB) is currently in discussions to raise up to €500 million for a new private credit fund. As traditional banks in the sector reduce their exposure to commercial real estate, borrowers are increasingly seeking alternative financing options. PBB aims to attract pension and insurance capital for senior real estate debt.
Investor returns in the real estate debt space have been strong. Real estate debt funds outperformed equity strategies in Europe last year, delivering a 3.7% return compared with -9.3% for equity vehicles, according to a new MSCI index. The MSCI Europe Quarterly Private Real Estate Debt Fund Index tracks the performance of 28 private real estate debt funds, which had a net asset value of €9.2bn at the end of 2023. The inaugural analysis noted that performance was mainly driven by whole-loan funds, which returned 7.4% last year. They comprise 28% of NAV in the index. Senior lending funds, which take a 53% share, also performed well at 5.8%. Meanwhile, subordinated and mezzanine debt funds, representing 16% of NAV in the index, recorded a -8.6% return. This still outperformed the MSCI Pan-European Quarterly Property Fund Index, which posted a -9.3% return for equity strategies over the same period.
Early in Bill Clinton’s first hundred days as president, his campaign manager James Carville made a remark that has since become famous. “I used to think if there was reincarnation, I want to come back as the President or the Pope… now I want to come back as the bond market. You can intimidate everybody.” Banks still very much ‘intimidate’, but debt funds are on the ascendant.