Private credit remains compelling but is operationally complex

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Private credit remains compelling but is operationally complex

Aani Nerleker & Nick Nolan, SS&C Advent

PARTNER FEATURE

As more alternative fund managers explore the yield opportunities in private debt, one of the risks is introducing too much complexity to their middle- and back-office operations. Outdated accounting and portfolio management systems or insufficient internal resources for tracking individual loan performance increase that risk.

Private debt AUM stood at USD575 billion at the end of 2016 and grew to USD848 billion by 2020. According to Preqin, the asset class will increase by 11.4 per cent annually to USD1.46 trillion by the end of 2025. Moreover, as Bain & Company’s Global Private Equity 2021 report reveals, the amount of dry powder for direct lending has grown 726 per cent since 2010, twice as much as any other alternative asset class.

Additionally, sell-side institutions expect the collateralised debt obligations (CLO) market to heat up due to the pent-up demand for new issuance amid tighter spreads. For example, Bank of America is forecasting USD300 billion of primary loan issuance in 2021.

Against this backdrop, hedge fund and private equity managers are converging on private credit to roll out new fund strategies and tap into the burgeoning asset class.

“More credit managers are originating private loans, and we see this across hedge funds and private equity,” says Aani Nerlekar (pictured, above right), Director, Solutions Consulting, SS&C Advent.

Operational rigour

One of the main operational challenges for private credit investors is ensuring that every moving element of the portfolio works in synch and leverages the same clean data set. An associated challenge is making the highly fragmented data more transparent.

The public equity and fixed income markets are standardised for corporate actions, event processing and dividends. Even reconciliations are a lot more straightforward, with custodians and prime brokers matching and triangulating data points.

But when you venture into private credit, there are no standard processes. As a result, loans may need to be processed manually, terms can change quickly, cash flows are irregular, and reconciliations are more challenging.

“We’ve seen clients struggle when there is a lack of data transparency,” says Nick Nolan (pictured, above left), Senior Director, Product Management and Solutions Consulting, SS&C Advent. “There are a lot of operational processes that work quite differently to public markets; it’s not just systems, it’s data, it’s reconciliation. So those are things our clients focus on, and where we try to help them – whether it’s with technology or managed services – to support new workflows.”

He notes that while some of SS&C Advent’s clients have, for quite some time, been investing in more traditional debt. Many of them are now originating their debt and coming up with their bespoke terms for cash flows and other features.

“As a result, our systems have needed to adapt to these changes as clients venture into more complex structures and types of investments,” he adds.

Managing interest payments from bank loans and self-originated loans, including unitranche, mezzanine and senior secured loans, can be operationally complex. Typically, it requires tracking multiple loans with scheduled versus ad hoc payment-in-kind, including term loans, delay draw loans, revolvers and loan total return swaps. In addition, if the portfolio is holding distressed loans, another operational consideration is effectively monitoring loan defaults and amortization of loan discounts.

Loan tracking can quickly become a challenging task for any fund manager to handle, no matter how sophisticated their internal operations might be.

Systems that lack automation, comprehensive multi-asset class coverage, and the technology infrastructure to draw data in from many sources potentially expose inferior, inefficient data management processes. Disparate information can reduce the capacity for both the front- and back-office teams to view each moving element of the portfolio in a single, consolidated manner.

Investors are more sophisticated and will look carefully at the operational rigour of those moving into the private debt space when conducting their due diligence. Likewise, managers with sophisticated IT systems will likely be better placed to demonstrate their ability to manage every complexity across the investment lifecycle. Ultimately, operational superiority can determine the success of the fundraising process.

“Investors do demand more of their managers in terms of transparency around how these funds are operationalised,” comments Nerlekar. “There are higher expectations from investors for look-through reporting and determining how much of each loan in the portfolio is being funded by an individual investor.”

Tracking fees and waterfall calculations

One of the issues that managers must contend with as private credit grows is more choice (for investors) and less opportunity to roll out standard, 2/20 fee structures. Instead, investors are increasingly looking to negotiate individual fee terms with the manager, meaning that the accounting process has to factor in cash flow movements across multiple fee structures and have the ability to calculate customized waterfall and carry structures terms.

The ability to track multiple cash flows is further accentuated by investors’ need for more opt-ins and opt-outs.

Historically, investors automatically participated in every investment, but now, managers are giving investors the option to participate (or not) in a deal because of customised terms.

As a result, managers will increasingly need to account for ‘deal by deal’ carry within the fund.

Now more than ever, it’s more important for managers to have a look-through system tightly integrated for all of these different components. For example, investment accounting, fund accounting and investor accounting – all three pieces are handled effectively by SS&C’s Geneva.

“We have the asset class coverage to fully support and manage the different terms of these loans, regardless of how large the overall fund structure is. So the user can understand where the asset is held, where the investors are coming in from, and how much capital they have,” concludes Nerlekar.

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