By Michel Degosciu, Managing Partner, LPX AG
Over the past few years, the private debt asset class is attracting serious investor attention due to several factors that have had a lasting impact on the credit market environment.
Within the Eurozone, traditional lending via the banking sector has been annihilated due to the legacy from the financial crisis in 2007/08.
Additionally, increased capital requirements due to Basel III legislative framework imply that banks have had little choice but to reduce their lending-volume in certain areas. The resulting gap is being closed by so-called “non-banks”.
These “non-bank” lenders have taken over parts of the traditional lending business of the banks and have also launched investment vehicles that offer investors the opportunity to participate in their private debt portfolio.
The aforementioned distortions in the traditional lending business have led to private debt increasingly being perceived as a separate asset class. This is demonstrated by the investment volume, which has risen steadily over the past few years (figure 1).
Figure 1 This figure shows the cumulative total return of the DLX Direct Lending Index vs. MSCI Financials Index from 31.12.2009 to 13.09.2022 based on daily data in USD (Total Return with dividends reinvested). Source: LPX AG.
According to Preqin, the volume was more than $848 billion in 2020. The volume of private debt funds raised in 2020 was approximately $118 billion. Preqin forecasts that private debt AUM to exceed USD 1.46 trillion by the end of 2025. The majority of the money is managed and invested in the US, where the “non-bank” sector is already an integral part of the overall credit market.
We anticipate that this development will also progress steadily in Europe as a result of developments since the financial crisis in 2007/08.
The Direct Lending Index (DLX)
The remarkable growth of the market compelled us to launch the first direct lending index – a measurement of the listed debt universe, through our DLX index.
The purpose of this was to provide the investment sector with a standard benchmark for the private debt asset class and to track the performance of companies that provide debt capital to unquoted companies.
Why we pioneered a listed direct lending index
Since the global financial crises, private debt has become its own asset class for investors. This has been driven by attractive post-global crisis credit opportunities and as a lucrative alternative to the low yields observed within traditional fixed income and credit markets.
Investors’ access to this market was nigh on impossible previously as it is a notoriously challenging one to track – a niche market without any standard definitions. The DLX Direct Lending Index overcomes this for investors, broadening investor access on a systematic basis that allows them to benefit from this burgeoning asset class.
The index itself, is based on a representative universe of stock market listed debt companies. As of August 31, 2022, a total of 41 companies can be identified worldwide.
And because the performance benchmark is a stock index based on market prices, this also allows for a direct comparison with other indices or benchmarks.
Performance versus the broader maker
Over the entire observation period since the global financial crises, the DLX Direct Lending Index shows an annualized geometric mean return of 10.35% with a standard deviation of 21.34%.
The MSCI Financials returns over the same period was 6.05% with a standard deviation of 19.03% (figure 2).
Figure 2 This figure shows the cumulative total return of the DLX Direct Lending Index vs. MSCI Financials Index from 31.12.2009 to 31.08.2022 based on daily data in USD (Total Return with dividends reinvested). Source: LPX AG.
We may be able to attribute the DLX Direct Lending Index’s outperformance versus the broader market, to certain attractive investment features:
- A high risk-adjusted return on average
- And a low correlation to traditional equity markets
- Stocks listed on the Index also have a comparatively high and stable dividend yield (figure 3 – 93% on average, as measured from 2009-21).
Figure 3 – Dividend yieldThis figure shows the average dividend yield (in percentage) of the DLX Direct Lending Index from 31.12.2009 to 29.12.2020. Source: Bloomberg, Dividend Indicated Yield – Gross (FLD: DV013).
For investors who focus on a steady dividend payment
Empirical results suggest that the integration of private debt into the strategic asset allocation improves the risk and return menu for an investor in stocks and bonds.
The stocks included in the DLX Direct Lending Index have a comparatively high and stable dividend yield. Against this background, we think the asset class is particularly attractive to investors who focus on a steady dividend payment in their asset allocation.
Tax giveaway is a boost for business, but will it drive growth or fuel inflation?
Chancellor Kwasi Kwarteng has announced a comprehensive wave of tax cuts and other incentives for individuals and businesses, as well as confirming some of the announcements made earlier this week. The measures are part of a new Growth Plan, which is aiming to boost economic growth. However, only time will tell if they will curb inflation and temper recession concerns.
Richard Godmon, tax partner at accountancy firm, Menzies LLP, said:
“With another fiscal statement to follow, this mini-Budget is a defining moment for the new Government and tax cuts are firmly back on the agenda.
“The biggest surprise was the decision to simplify Income Tax by moving to a single higher rate of tax for high earners of 40%, with effect from April next year. This will encourage a spirit of entrepreneurialism by incentivising work and putting money back into the economy. The flip side is that the Government might also be hoping that the move increases the tax take, as it could help to draw people back to the UK who may have previously chosen to live and work elsewhere, while encouraging others to stay put.
“The reduction in dividend tax rates and the abolition of the additional rate of tax from April 2023 means that business owners will need to consider carefully the timing of dividend payments over the next few months.”
Up to 40 new Investment Zones
The Chancellor also outlined plans to create up to 40 new ‘investment zones’ in England, with the potential for more in Wales, Scotland and Northern Ireland. Businesses in these zones will benefit from wide-ranging tax breaks including 100% tax relief on investments in plant and machinery, and no National Insurance Contributions will be payable on the first £50,000 earned by new employees.
Richard Godmon, tax partner at Menzies LLP, said: “The new Investment Zones are reminiscent of the former Enterprise Zones, but they will provide a much more favourable tax environment for businesses and they promise to become a magnet for inward investment. There are currently 38 areas in England on the list for consideration and we look forward to finding out which ones will be selected.”
Incentivising business investment and Corporation Tax rise ‘cancelled’
The limit of the Annual Investment Allowance (AIA) will not revert to £200,000 as planned in April next year, it will now permanently stay at £1 million.
Richard Godmon, tax partner at Menzies LLP, said:
“Capital allowances are highly valued by businesses and they will be pleased that this one in particularly is going to stick at £1 million and that this is no longer being described as a temporary measure, but is to be made permanent.
“The decision to cancel the planned increase in Corporation Tax (due to tax effect next April) will be a relief to many small and medium-sized businesses who have been concerned that this increase would erode profits further and make it even more challenging to remain viable.”
Incentivising entrepreneurial investment
The Chancellor highlighted plans to increase the cap on investments that can be made under the Seed Enterprise Investment Scheme (SEIS) from £150,000 to £250,000. Individuals making investments in start-ups up have had the limit doubled to £200,000, with the 50% income tax relief remining the same. The Government also gave its commitment to continuing to back the Enterprise Investment Scheme (EIS).
“These announcements send a signal to entrepreneurial investors that tax should not be a barrier and the Chancellor wants to expand incentives in this area,” added Richard Godmon, tax partner at Menzies LLP.
Stamp Duty Land Tax
The threshold at which Stamp Duty Land Tax (SDLT) becomes payable on residential property purchases in the UK has been raised to £250,000, double its previous level in a bid to boost the property market. In addition, first-time buyers will not have to pay SDLT on property purchases up to a value of £425,000 (up from £300,000). Both measures will take effect from today.
Richard Godmon, tax partner at Menzies LLP, said:
“The decision to raise the SDLT threshold is designed to build consumer confidence and boost the housing market generally. For property developers it will fuel activity by creating demand, particularly from first-time buyers, and help to free up finance to front-end development projects.”
Richard Godmon, tax partner at Menzies LLP, said:
“The repealing of the 2017 and 2021 IR35 changes will be hugely welcomed as it will remove an administrative burden, risk and cost, enabling businesses to devote resources to furthering their growth strategies.
“It is important to recognise that IR35 has not been abolished and the result of the changes is that the risk and compliance costs are being returned to the individuals and their personal service companies. HMRC will no doubt redirect their focus towards the contractors, which will bring challenges and make enforcement more difficult.”
A zero trust environment is critical for financial services
Not long ago security professionals were still focused on protecting their IT in a similar formation to mediaeval guards protecting a walled city – concentrating on making it as difficult as possible to get inside. Once past this perimeter though, access to what was within was endless. For financial services, this means access to everything from personal identifiable information (PII) including credit card numbers, names, social security information and more ‘marketable data’. Unfortunately, we have many examples of how this type of security doesn’t work, the castle gets stormed and the data isn’t protected. The most famous is still the Equifax incident, where a small breach has led to years of unhappy customers.
Thankfully the mindset has shifted spurred on by the proliferation of networks and applications across geographies, devices and cloud platforms. This has made the classic point to point security obsolete. The perimeter has changed, it is fluid, so reliance on a wall for protection also has to change.
Zero trust presents a new paradigm for cybersecurity. In this context, it is already assumed that the perimeter is breached,no users are trusted, and trust cannot be gained simply by physical or network location. Every user, device and connection must be continually verified and audited.
What might seem obvious, but begs repeating, with the amount of confidential customer and client data that financial institutions hold – not to mention the regulations – this should be an even bigger priority. The perceived value of this data also makes financial services organisations a primary target for data breaches.
But how do you create a zero trust environment?
Keeping the data secure
While ensuring that access to banking apps and online services is vital, it is actually the database that is the backend of these applications that is a key part of creating a zero trust environment. The database contains so much of an organisation’s sensitive, and regulated, information, as well as data that may not be sensitive but is critical to keeping the organisation running. This is why it is imperative that a database is ready and able to work in a zero trust environment.
As more databases are becoming cloud based services, a big part of this is ensuring that the database is secure by default, meaning it is secure out of the box. This takes some of the responsibility for security out of the hands of administrators because the highest levels of security are in place from the start, without requiring attention from users or administrators. To allow access, users and administrators must proactively make changes – nothing is automatically granted.
As more financial institutions embrace the cloud, this can get more complicated. The security responsibilities are divided between the clients’ own organisation, the cloud providers and the vendors of the cloud services being used. This is known as the shared responsibility model. This moves away from the classic model where IT owns hardening the servers and security, then needs to harden the software on top – say the version of the database software – and then needs to harden the actual application code. In this model, the hardware (CPU, network, storage) are solely in the realm of the cloud provider that provisions these systems. The service provider for a Data-as-a-Service model then delivers the database hardened to the client with a designated endpoint. Only then does the actual client team and their application developers and DevOps team come into play for the actual “solution”.
Security and resilience in the cloud are only possible when everyone is clear on their roles and responsibilities. Shared responsibility recognizes that cloud vendors ensure that their products are secure by default, while still available, but also that organisations take appropriate steps to continue to protect the data they keep in the cloud.
In banks and finance organisations, there is always lots of focus on customer authentication, making sure that accessing funds is as secure as possible. But it is also important to make sure that access to the database on the other end is secure. An IT organisation can use any number of methods to allow users to authenticate themselves to a database. Most often that includes a username and password, but given the increased need to maintain the privacy of confidential customer information by financial services organisations this should only be viewed as a base layer.
At the database layer, it is important to have transport layer security and SCRAM authentication which enables traffic from clients to the database to be authenticated and encrypted in transit.
Passwordless authentication is also something that should be considered – not just for customers, but internal teams as well. This can be done in multiple ways with the database, either auto-generated certificates that are needed to access the database or advanced options for organisations already using X.509 certificates and have a certificate management infrastructure.
Tracking is a key component
As a highly regulated industry, it is also important to monitor your zero trust environment to ensure that it remains in force and exompasses your database. The database should be able to log all actions or have functionality to apply filters to capture only specific events, users or roles.
Role-based auditing lets you log and report activities by specific roles, such as userAdmin or dbAdmin, coupled with any roles inherited by each user, rather than having to extract activity for each individual administrator. This approach makes it easier for organisations to enforce end-to-end operational control and maintain the insight necessary for compliance and reporting.
Next level encryption
With large amounts of valuable data, financial institutions also need to make sure that they are embracing encryption – in flight, at rest and even in use. Securing data with client-side field-level encryption allows you to move to managed services in the cloud with greater confidence. The database only works with encrypted fields and organisations control their own encryption keys, rather than having the database provider manage them. This additional layer of security enforces an even more fine-grained separation of duties between those who use the database and those who administer and manage it.
Also, as more data is being transmitted and stored in the cloud – some of which are highly sensitive workloads – additional technical options to control and limit access to confidential and regulated data is needed. However, this data still needs to be used. So ensuring that in-use data encryption is part of your zero trust solution is vital. This also enables organisations to confidently store sensitive data, meeting compliance requirements, while also enabling different parts of the business to gain access and insights from it.
Securing data is only going to continue to become more important for all organisations, but for those in financial services the stakes can be even higher. Leaving the perimeter mentality to the history books and moving towards zero trust – especially as cloud and as-a-service infrastructure permeates the industry – is the only way to protect such valuable data.
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