Private debt is flourishing.

The most recent Preqin figures show private debt assets under management hit a record $769 billion as of June 2018[1]. Assets are expected to grow further in 2019, with almost half of investors planning to expand their allocation over the longer term. The Alternative Credit Council (ACC) predicts the sector will reach $1 trillion by 2020[2].

Why?

Traditional bank lending contracted post-crisis, as banks deleveraged to reduce risk and meet tighter capital requirements. But institutions and corporates still need financing. Private debt (i.e. debt investments not financed by banks, and not issued or traded on an open market) has flooded in to fill the gap, especially in the US and parts of the EU.

Mid-market corporates historically formed the bulk of borrowers. But lending now extends to everything from startups and small businesses to large corporations and infrastructure projects, notes the ACC—with capital increasingly being used in areas such as real estate, trade and asset-backed finance.

Private equity firms have been at the forefront of the private debt financing boom. And institutional investors have followed their lead. They now account for over 70% of the capital committed to the growing number of private debt funds, drawn by the promise of diversification, attractive yields and reliable income streams. Pension funds, with their long investment horizons and demand for stable returns, have become particularly active allocators.

Risk and rewards

Inevitably though the attractions have trade-offs.

Private debt borrowers pay a premium because they may be too small or high risk for the public debt markets. Such borrower profiles make robust risk management ever more vital.

Liquidity terms are longer as well. To avoid a potential mismatch between assets and liabilities, private debt funds often require a hold-to-maturity approach, with the best yielding offerings potentially tying up capital for several years.

The influx of capital and launch of new funds is also intensifying competition. In response, private credit managers may be forced towards lower-quality deals, with poorer terms and/or reduced returns—at a time when we’re nearing the end of the current credit cycle and face the prospect of tougher economic conditions for borrowers.

Investor servicing demands

The growing cohort of institutional investors bring greater due diligence and ongoing servicing requirements too.

The ACC report notes that a sizable majority of private credit managers are “willing to run separately managed accounts”—an effort to meet investor calls for customized fee arrangements, and demands for greater transparency and control over their investments.

Managing the accounts efficiently is crucial. Heightened (often bespoke) investor reporting expectations increase the operating burden.

Operating complexities

And administering private debt—with the associated accounting and reporting requirements it brings—presents particular challenges.

Private debt can be more flexible and bespoke than typical bank loans or public debt instruments, and may require specific operational expertise and technology capabilities to manage the risks and deliver the necessary services to investors.

Common challenges/pain points include:

• Combining debt and equity—private debt is often rolled up with equity-type arrangements, in which case the equity and debt need to be tied together from an accounting and reporting perspective.
• Complex structures—along with public and private companies, borrowers are often special purpose vehicles (SPVs), which bring heightened governance, exposure monitoring and transparent reporting requirements.
• Hybrid funds—private debt offerings are often structured within closed-end funds. This requires the ability to account for hybrid fund structures, and look-through those structures to follow the cash.
• Accounting standards—under IFRS 9, financial instruments need to be correctly classified and measured, with the treatment varying depending on whether they are held for trading or lending purposes.

Importance of systematizing

Yet while the administration demands may be higher, spreadsheets remain an all-too-common feature in the private debt world. And as we all know, they bring significant operational and financial risks.

Loans lend themselves to templates. Just tweak the terms and voila! But templated spreadsheets mean any problems that creep in will be reused and filter across the organization. Flexible rounding rules for calculating interest in a spreadsheet can similarly compound financial errors.

Efficiency and scalability issues are another factor. Having to build or reconfigure a spreadsheet every time a new loan or piece of business is brought on takes time and resources.

By contrast, a flexible yet robust system with the functionality to accommodate loan administration and accounting, and that can track and report on the debt, will enable firms to efficiently monitor and manage their risks. Isn’t the ability to profit from the enormous and growing opportunity private debt offers worth the investment?

 

[1] 2019 Preqin Global Private Debt Report, Preqin, Feb 21, 2019, https://docs.preqin.com/samples/2019-Preqin-Global-Private-Debt-Report-Sample-Pages.pdf

[2] Financing the Economy 2018 – The role of private credit managers in supporting economic growth, Alternative Credit Council and Dechert LLP, https://www.aima.org/educate/aima-research/fte-2018.html