As credit risks increase, dry powder accumulates and the demand for transparency rises, it is crucial for private credit firms to adapt their due diligence processes and portfolio monitoring methods to stay competitive and optimize performance.
By Abhik Pal, Global Head ESG and Research Practice, CRISIL
The private credit market has undergone a period of rapid growth since the Global Financial Crisis of 2008, particularly as private lenders have stepped in to fill the gaps left by banks in lending to small- and medium-sized businesses. Preqin and S&P Global Ratings research data show that assets under management for funds focused on direct lending alone grew tenfold from around $39.9 billion in 2010 to $412.1 billion in 2020. In addition, while historically a sub-category of private equity, private credit has emerged as an asset class in its own right and it is expected to become the second-largest private capital asset class by the end of this year.
While AUM in the private credit sector may have grown rapidly, best practices have not necessarily kept pace, and some of the most promising methods and technologies have yet to be widely adopted. Although this this has not dampened demand for private credit strategies — it was the only large alternative asset class with growth in fundraising in 2022 — the sector now faces its first real test as a genuine asset class. Rising interest rates, the increasing prospect of recession and the potential for an increase in defaults all present threats. Increased investor demand for transparency, credit risks and accumulating dry powder are only a few of the sector’s other challenges.
Against this backdrop, institutional investors are increasingly inclined to invest with private debt managers who utilize advanced analytical-based due diligence techniques and engage in partnerships with third-party entities throughout the value chain, ranging from deal sourcing to reporting and surveillance. To help asset managers and financial institutions, here are some best practices that are key for private credit firms who wish to differentiate themselves, best insulate themselves in a deteriorating economic environment and ultimately gain a competitive edge.
Build a Centralized Information Repository to Shore Up Monitoring
Private credit asset managers are increasingly adopting the practice of a centralized “information repository” to enhance portfolio surveillance and reporting. These repositories store and track key information about each investment, such as financial performance and debt covenants. By maintaining a centralized information repository, asset managers can track key investment metrics constantly, immediately spot potential issues and take appropriate action to mitigate them. Internal cloud-based tools and platforms not only centralize information; they also provide users with access to investment parameters, performance and risks to ensure real-time monitoring.
To keep these repositories up to date, asset managers employ a team of analysts and professionals who collect and analyze data from each investee company. These repositories improve investor reporting and help to build trust and transparency between asset managers and their investors.
Overall, the trend toward creating centralized information repositories is driven by the dual need for better portfolio management and comprehensive investor transparency and reporting.
Strengthen Internal Valuation Processes and Advance Analytics to Mitigate Valuation Trust Gaps
Private credit asset managers are increasingly turning to domain-led third-party valuation service providers to improve the frequency, accuracy and scale of valuations. By engaging external service providers who employ best-in-class practices, credit expertise and advanced analytics, asset managers can accurately determine and monitor the fair value of their private investments. The usage of advanced analytics, machine learning and increasingly generative artificial intelligence, has allowed firms to analyze large data sets and identify trends, thereby boosting the accuracy of their assessments. Predictive analytics and statistical modelling identify patterns and trends in the financial data of investee companies that may not be immediately apparent to deal teams.
Domain-led third-party service providers also have allowed asset managers to comply with regulatory requirements better while simultaneously providing investors with more transparency and accuracy in valuations. For asset managers striving to improve portfolio performance and enhance transparency for investors, the practice of leveraging a third-party service provider is quickly becoming the standard in the private credit sector.
Collaborate With Private Equity Sponsors to Address Due Diligence Challenges
Private lenders are increasingly looking to finance large private equity takeovers, taking advantage of the withdrawal of investment banks and banking players from the market. In this context, sponsors and borrowers are increasingly looking for longer-term partnerships with private credit solutions offering additional flexibility, reliability and speed of execution. This collaboration can also lead to the adoption of innovative practices that improve the due diligence process, as private equity sponsors have access to advanced analytics tools that private credit firms can leverage.
We are already seeing this type of collaboration happening in the market. For instance, private credit firm Ares Management teamed up with private equity firm Trilantic North America to acquire a majority stake in healthcare services company Iris Telehealth. By collaborating with Trilantic North America, Ares Management was able to leverage its expertise in healthcare investments and improve its due diligence process. Similarly, private credit firm Monroe Capital formed a strategic partnership with private equity firm Arsenal Capital Partners. The partnership aims to provide credit solutions to middle-market companies in the specialty industrials sector. By collaborating with Arsenal Capital Partners, Monroe Capital hopes to expand its investment portfolio and improve its overall performance.
Working with private equity sponsors can also build relationships, expand networks of potential investment opportunities and improve deal flow. Overall, private credit firms that collaborate with private equity sponsors can gain a competitive advantage and improve portfolio performance.
While collaboration with third parties and private equity sponsors, as well as adopting the latest analytics-driven due diligence methods, has not yet become widespread, these best practices hold the potential to reshape the industry. These practices can help asset managers identify emerging stress ahead of time and enhance portfolio performance. Given where we are today with advanced analytics and an expanded data set, lenders can better mitigate risk and free up capital for increased lending by employing these best practices.