How have the issues facing private credit managers evolved in the past decade?
Andrew Kyung: The private credit asset class has seen significant growth over the last 10 years. The challenges for managers have become more complex in a variety of different ways. In addition to rapidly increasing interest rates, there have been notable increases in tax and reporting regulations and the general information needs of investors.
Greg Myers: Private credit managers comprise a much larger proportion of corporate lending and M&A lending compared with 10 years ago. As banks retrench, direct lenders are among the first group of people contacted when there is a big deal or borrowing requirement from corporate institutions. Competition for those deals has increased and there is now an almost institutional expectation from borrowers that wasn’t there in the past when these funds were regarded as opportunistic lenders.
Now, the expectation is of a formalised infrastructure on a par with what borrowers would see from a large banking institution, placing pressure on credit managers that did not exist a decade ago to build out the requisite platform to support direct lending operationally.
What are the biggest challenges and opportunities they face today?
AK: I think one of the biggest challenges for managers is how to best collect data and use technology to streamline workflows and enhance processes across the firm. Many alternatives managers have invested in some type of data warehouse for that purpose.
Identifying the right system to achieve those goals for credit investments can be especially challenging due to the additional data points, calculation requirements and volume of transactions related to the asset class. Partnering with a good fund administrator specialised in credit investments can make a big difference, and can help to find the right balance between leveraging technology and use of limited internal resources.
GM: Management companies need to decide how they are going to allocate staff, systems and costs in a world of limited resources. Do you build all that institutional grade infrastructure internally or opt for external providers? Or is there some way to marry the two that differentiates you from other managers in terms of raising capital and meeting your reporting requirements? Given the breadth and depth of third-party service providers, many managers elect to build in-source/outsourced models that marry the best systems, internal and external resources.
How can fund administrators provide support to managers looking to keep their back-office functions efficient and compliant?
AK: It can be difficult to find a single service provider to augment what you would otherwise have to build in-house for accounting, operations, reporting and performance tracking for private credit investments. Investment accounting, fund accounting and investor accounting can require their own dedicated systems. Fund administrators specialised in loans can enhance a credit manager’s ability to find a scalable solution and take advantage of these specialised systems.
GM: What is important for most asset managers is to make sure the fund administrator has the systems to satisfy all those elements of their organisation and to enhance and support all those different areas of the business. Given the different needs from the front, middle and back offices, it is important to consider the various requirements of those constituencies when selecting that administrator.
ESG has been a big theme in the past decade, and ESG data will be a big theme for the next decade. What do managers need from fund administrators in that area?
AK: For managers seeking to integrate ESG considerations and collect data points during the investment process and throughout overall portfolio operations, getting that data into a system and a useable format is one of the best ways that fund administrators can help managers to leverage those with ESG goals.
GM: What managers need here really varies. Our systems are able to capture and track the different ESG data points, so it becomes a question of the extent to which it is collected and reported on. It is the ability of an administrator to track that data and report consistently on the results that provides the most valuable support to managers.
Ten years from now, what do you think credit managers will be focusing on in relation to ESG?
AK: Ten years from now, I think credit managers focused on ESG will be looking to see the impact on their investments.
GM: Being a realist, I think there is going to be a divergence of managers based on their investor base. There are going to be ESG funds and non-ESG funds, and it will be interesting to see how the two perform when we look back.
I will be curious to see how the Securities and Exchange Commission and institutional investor groups agree to a coherent approach to ESG and DE&I, so it is hard to imagine how the approach will play out.
Which regulatory developments on the horizon will most impact private credit managers?
AK: I think there will be more convergence between US and international regulations. I imagine developments will continue to focus on tax and performance reporting. The growth of the asset class will likely lead to an increase in regulations specific to credit investment managers and direct lenders.
GM: Because of the proliferation of private lending across the US, a lot more states are going to start regulating asset managers’ direct lending to companies based in their states. That is going to become a big focus because that framework exists for banks but does not so far exist for direct lenders.
How is investor demand for private credit evolving over time, and what strategies and regions are currently attracting the most LP interest?
AK: Leveraged senior loan portfolios have been successful in a few forms and there seems to be some renewed interest in mezzanine funds. I believe LP demand for private credit continues to grow, but so is the competition for those commitment allocations. Managers will need to continue to differentiate themselves. I think it helps to have the right mix of strategy offerings, and the service and technology infrastructure to provide the information transparency and portfolio data investors desire.
GM: Credit is now a very well understood asset class compared with a decade ago, so allocations will continue to increase, just as they have in private equity. Investors are going to maintain those allocations moving forward – a big attraction is that most of the assets are in variable rate assets, so they can track up as interest rates increase.
As far as regions are concerned, Europe and North America continue to be strong. Asia will continue to have attractions for private credit managers as manufacturing leaves China for other parts of Southeast Asia.
On strategies, we see a growing number of asset managers focused on lending to funds, almost as a competitor to the traditional role the investment banks played in providing subscription lines. That is a relatively new strategy, but the ability of managers to source and access leverage for funds has become increasingly challenged. Those credit lines that managers use to increase or enhance returns, or for the bridging of investor capital, will be a growth area for private credit in the next decade.
What have been the biggest drivers of the outsourcing trend to service providers in the past decade?
GM: There is a much better understanding in the institutional investor space that these funds have certain expenses that need to be allocated to them, and that fits well with having an outsourced fund administrator model where those costs can be directly borne by the fund. You do not need as many internal staff to monitor the outputs of those external service providers, so it ensures a leaner infrastructure. Given skill shortages and the dearth of hiring talent, the other big driver is the access we provide to experienced professionals.
AK: The ability to tap into technology that would otherwise have to be developed in-house, alongside a stable service team, has definitely become more important through covid and an unexpectedly more challenging post-covid era.
What will fund administrators need to do to stand out and meet manager demands in the next 10 years?
GM: The priority will need to be continued capital investment in technology, systems and delivery mechanisms to get data out of fund administrators’ systems and into managers’ data warehouses. The number one requirement for our clients is data.
AK: When it comes to data and technology, managers and fund administrators all seem to be at a common crossroads regardless of size. Everyone is trying to find a way to collect and use data to build efficiencies, create additional value and differentiate themselves. One of the biggest challenges is finding the right mix of technologies and services to achieve those objectives, at a cost that makes them scalable.
This article was originally published in PDI's Decade of Outsourcing Report. Greg Myers is Group Sector Head of Debt Capital Markets at Alter Domus and Andrew Kyung is Controller and Vice-President, fund administration at AEA.