Wednesday, 29 March 2017
Last updated 56 min ago
Mar 8 2017 | 9:24pm ET
Editor’s note: The explosive growth of private debt over the past few years has caused the lines between alternative credit and private equity to blur. As institutional portfolios increasingly deploy capital to direct lending and other credit vehicles, private debt now anchors the growth aspirations of many PE firms. However, as explored by the team at SEI, managers entering the private debt space should not underestimate the operational, administrative and regulatory challenges unique to the asset class.
Private Debt Coming Into Its Own
In SEI’s recent paper entitled The Future of Private Equity, we found that the term “private equity” itself is becoming a misnomer, as direct lending vehicles take market share from banks, making private debt a cornerstone of many private equity firms’ growth strategies. According to Preqin research, interest in private debt has exploded in recent years and can now be found in more than half of all institutional portfolios.
Investors have been drawn to private debt as an asset class for a variety of reasons, including competitive returns and diversification benefits provided by an asset class that has historically exhibited low correlations to other types of investments. Private debt comes in several flavors, and there doesn’t appear to be a current consensus on which of these is likely to prove the most attractive over the coming year. In a survey of managers and investors, we found that GPs and consultants saw special situations debt as particularly appealing while LPs were more likely to be drawn to distressed debt. Direct lending strategies are also receiving considerable attention, as nonbank lenders continue to proliferate, servicing more niches and increasingly securitizing their lending portfolios.
Many managers have private debt funds offered alongside private equity, real estate and hedge funds. However, managers entering the private debt space should not underestimate the operational challenges unique to the asset class.
Operational Issues For Firms Offering Private Debt For The First Time
For those firms with an established private equity infrastructure, they will need to transition their back office to handle more complex investment portfolio accounting. Given the complexity of monitoring the securities (PIK, floating rates, conversion to equity, etc) and the much higher volume of transactions compared to equity (involving amortization, interest accruals and payment and capital distributions of income to investors), managers wishing to offer private debt should pay special attention to the operational infrastructure supporting the asset class.
Applying the waterfall carried interest fee structure to private debt is also a pain point. GPs with deal-by-deal limited partnership agreement terms, in particular, may have to combine hundreds of thousands of portfolio transactions with their investor capital allocations. All agreements have unique needs and GPs need to carefully audit these calculations.
Many see their LP-GP fee calculations as a key risk area. The more liquid strategies have commonality with hedge funds from an operational point of view, but there are challenges here too. Today’s global private debt managers have more complex tax entity structures to administer. On the investment side, holding companies and SPV entities create a spider web of entities for audit and tax to professionals and interested parties. For any given fund, there may be hundreds of these entities. Multiply this with the number of transactions and it becomes a massive amount of data, with a massive amount of opportunity for error.
On the investor capital and tax side, complex legal entities are also the standard for GPs with institutional investors. Blockers and AIVs set up for tax advantages further multiply the support needed for experienced fund accounting resources. More and more managers are reporting these entities externally to their investors to meet demands and provide transparency.
Operational Challenges Dffer Depending On What Side of The Pond You’re On
Over the past few cycles, the European private debt industry has enjoyed significant fundraising success. Direct lending strategies have been of particular interest as they are now an integral part of many institutional investment portfolios.
While the US remains #1 in terms of fundraising and deal activity, Europe has seen a huge growth in the sector since the financial crisis. From an operational perspective, elements of European fund structuring such as whole-of-fund, rather than deal-by-deal waterfall requirements can ease the complexity of accounting requirements for the back office. However, especially for pan-European funds, back-office administration can become more convoluted with multi-jurisdictional structural, legal, tax and regulatory challenges at the investment and investor level. In particular, for the latter, regulatory developments such as Solvency II, the new regime for the prudential regulation of European insurers, imposes data reporting requirements for insurance company LPs that will typically pass this on to fund managers.
From an origination perspective, European debt managers still see a strong pipeline of non-bank lending opportunities, albeit with increased competition. The key to effective and efficient pan-European investment origination is the need to build a local presence in each country. Having knowledge and scale within each of the markets in question, with understanding of local legislation and security enforcement issues, is key. This affects the choice of technology and operations from an operational infrastructure perspective as fund managers look to provide their teams with up-to-date fund, investment and investor data, no matter which office they are based in.
Outsourcing Can be a Help
Private debt managers are increasingly aware of their deficiencies or comparative disadvantages compared to specialist fund administrators in this area. As regulators and institutional investors start to pressure managers to improve their processes and systems, managers are more amenable to outsource certain functions that can both enhance a GP’s ability to manage data, monitor complex strategies and handle customized investor reporting, but also reduce regulatory and operational risk.
In the traditional fund marketplace, it is more common than not for a manager to outsource (some portion of) their accounting and technology functions. Even in the hedge fund space, using an independent third-party provider is the norm, but private equity and debt managers (particularly in the US) have yet to embrace this trend as widely.
This is changing rapidly, especially for those managers that invest across asset classes and manage multi-strategy or hybrid portfolios. These managers have worked with expert providers to blend the most appropriate technology from private equity, hedge and real estate to suit their (and their clients’) needs.
Challenges Looking Ahead
The maturity of private debt as a strategy or asset class, combined with new reporting pressure, is stressing the back office. A high and increasing percentage of all private debt fund closures and capital raised were by managers raising their subsequent fund (second, third, fourth, fifth, sixth). While subsequent funds were closed in 2016, many of the credit crisis vintage year predecessor funds have not been fully liquidated. Managers must therefore juggle funds at all stages in the lifecycle. Even for larger firms with substantial resources, the growth and variety of vintages is putting added stress on the back-office accounting, tax and investor servicing teams.
Compounding the operational strain on the back office, investors are also pressuring managers for reporting: more reports, more frequently, and with more detail. In 2016, the Institutional Limited Partners Association (ILPA) published fee reporting standards which require not only additional reports for investors, but new levels of fee and expense detail. While investors recognize time is needed for managers to respond, the expectation from them is clear: this is the new standard of disclosure.
SEI is a leading global provider of investment processing, investment management, and investment operations solutions. Through its Investment Manager Services division, the company provides operational outsourcing services and fund administration globally across a wide range of registered and unregistered fund structures, investment strategies and jurisdictions.