The private debt market has been a significant growth story for some time. As we now look at a backdrop of rising short-term interest rates, iCapital sees investors looking to private credit as “a significant buffer over publicly traded high-yield or leveraged loans.”
Yet, such front-office growth only hints at the implications behind the scenes. As a provider of loan market solutions, we see this trend through an operational lens. Private lending creates demand for innovation and flexibility in loan market services.
As activity grows, market needs evolve, too. Therefore, a better understanding of the operational implications of what they would like to do can help private lenders make better choices in the service providers to support them.
From bespoke needs to bespoke servicing
In the world of broadly syndicated loans, loan agency activities remain generally similar from deal to deal. The Loan Syndications and Trading Association (LSTA) in the U.S. and the Loan Market Association (LMA) in Europe create a high level of standardization in loan documentation. Consequently, the requirements for a loan agent are quite clear in advance. Although expertise in servicing loans and robust infrastructure still have great importance in the efficient and proper handling of a transaction, many of the core activities are relatively straightforward, such as interest and principal payments to the syndicate.
By contrast, private credit can vary significantly, not only between asset managers but between funds. Without having to meet the capital requirements and other regulated standards of a bank lender, private funds have a wide range of choices. These options can include borrower credit quality, the pace of distribution of delayed draws to borrowers, sector or segment specificity, and more. Ultimately, the idea is to create a product with an attractive return profile for investors while seeking to mitigate credit risk.
The breadth of factors that define a private credit fund’s strategy significantly impacts the loan lifecycle from origination to trading activity on the fund’s loans. They also manifest in the various types of reporting provided to investors. So, on the one hand, flexibility has driven the success of private lending, giving both borrowers and investors more options to choose from. On the other hand, the lack of standardization creates additional complexity.
The impact of complexity
The impact of more complex servicing scenarios raises the bar for back-office resources—those within the fund itself and those provided by a loan agent. After all, operational missteps can slow trades, hamper payment, frustrate investors, and create significant headaches for asset managers.
As a result, a loan agent must be able to translate loan documentation into specific actions they will carry out in servicing the transaction. Loan agents also need to have the necessary experience and expertise to deal with situations where loan documents are ambiguous. The bespoke nature of private lending makes those ambiguities and grey areas more likely.
Finally, many of the standard platforms for managing the details of loan processing do not always support custom requirements out of the box. They assume a certain degree of process standardization. Asset managers therefore benefit from keeping up an ongoing conversation—from RFP to subsequent discussions—about the technology and operational capabilities of loan agents. Can prospective agents quickly customize or extend their current systems to deliver? In areas where technology cannot support desired workflows or reporting, do they have the in-house skills and capacity to handle requirements manually while managing risk appropriately? Such questions help connect the dots between what managers need and what agents are equipped to provide. They help manage the balance between cost and complexity, helping establish a mutually best approach. They also have downstream implications for reporting as well as trustees, custody providers, and other service providers, adding another layer to the need for agents to handle them effectively and at scale.
The question of customization also suggests that the private credit market may include a trend that runs counter to the financial industry’s tendency to focus on greater and greater automation. While applying automation makes sense in more rote scenarios and can result in less cost and complexity, private lender needs are also spawning something like a “return to manual” to handle some aspects of a transaction, such as non-pro-rata actions, delayed draw, bespoke cash flows, revolvers, and restructuring. While these do create a need for manual processing, they also raise the bar for agents to have the flexibility and expertise to do so while minimizing the risks of errors or weakened controls that can emerge when using spreadsheets.
Smarter due diligence
The impacts of such complexity lead us to conclude that one of the most essential criteria for selecting an agent is their ability to understand requirements and respond to questions in depth. A quick and easy “yes” response to tough questions about systems, skills, and capacity may feel reassuring in the moment, but it can also lead to severe disappointment later. Sometimes “no, but” is better for both parties by providing lower-risk, higher-efficiency alternatives. In other words, not every agent can get every deal right.
To respond to this dynamic, Wilmington Trust focuses on building relationships and collaborating with client teams from both the front and back office. In addition, we pay close attention to the needs and implications of a potential deal, from standard servicing workflows to possible exceptions and risks. As a result, our clients and we each have a more detailed understanding of what will happen during the term of a loan, allowing for efficient and safe servicing throughout.
A final word
Because the private lending market has experienced such significant growth, it has also created room for a wide range of service providers. While the resulting degree of competition is positive for the industry overall, it does mean that private lenders must carefully evaluate the capabilities and experience of service providers with ever-greater scrutiny. Getting it right at the beginning is essential for mitigating risk. Absent a move towards greater standardization in private lending, a clear view of the causes and implications of bespoke approaches to deals is the most prudent way to proceed.
2 https://www.icapitalnetwork.com/insights/outlook/2022-outlook/ (pages 17)
3https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors/our%20insights/mckinseys%20private%20markets%20annual%20review/2021/mckinsey-global-private-markets-review-2021-v3.pdf (page 44)
Wilmington Trust’s domestic and international affiliates provide trust and agency services associated with restructurings and supporting companies through distressed situations.
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