The alternatives industry has doubled in size in the past six years to become a $9 trillion asset class. The drivers behind this growth – investment diversification, increased potential returns and alpha generation – are expected to continue. Bain & Co estimates assets under management in private market investment will double again by 2026. Institutional investors’ portfolio allocation to alternatives is increasing, growing by half between 2015 and 2019 to around 22 percent.

The industry is buying more complex assets and managing them across more jurisdictions. Investment managers are facing increased pressure from institutional investors to generate alpha to help balance the liability side of balance sheets, ie, pension and insurance liabilities. This, combined with increasing regulation on bank lending, brings new opportunities, but also new challenges for private debt fund managers.

With a growing influx of capital being pooled into all areas of private debt, new challenges have arisen for managers and investors. Most notably, institutional investors have historically been accustomed to publicly available information on underlying credits, and valuations thereof, as is the case with traditional debt instruments such as bonds.

However, this level of disclosure is harder to obtain within private credit. As such, surveillance and risk management of private credit products and underlying debt instruments becomes much more difficult and requires substantial expertise and enhanced technological capabilities to ensure accuracy.

Complex and distracting

Fund managers earn their fees through in-house expertise in originating and managing attractive private debt investment opportunities. However, as their portfolios grow and their investment horizons broaden into new regions and types of private debt, credit surveillance and risk management look-through and oversight tasks can become too complex and distracting to handle in-house.

These challenges contribute to a complex and multi-layered process requiring specific and deep expertise. The increasing staff costs associated with attracting talent with the requisite experience, and a requirement to satisfy both clients and regulators with truly independent services for private debt assets and portfolios is leading private debt investors to mandate qualified, independent third parties to support their credit surveillance processes.

Additionally, many private debt managers are burdened with legacy technology systems often cobbled together over the years from different platforms. Utilising a trusted partner with enhanced technological capabilities takes the burden off managers in terms of transitioning away from legacy systems, which would otherwise require a full overhaul. By using a trusted outsourcing partner, managers can deliver the highest level of accuracy and transparency for their investors and regulators.

Likewise, as private debt managers deploy capital into increasingly complex investment opportunities that require appropriately skilled staff and advanced systems, regulators and auditors are, in response, applying additional pressure on fund managers to deliver more transparent and current asset valuations.

The UK Financial Conduct Authority dictates that valuations must be undertaken independently from portfolio management. In cases of complex, private credit investments, AIFM fund managers that conduct valuation exercises internally are having to direct resources towards employing highly sophisticated (and expensive) staff who will be required to operate behind safe-guarded walls from their fund managers. Even then, the integrity of the valuation process will need to be audited internally, and perhaps externally, introducing further expense.

So, in the face of this growing scrutiny and complexity, how can fair market values be determined? The challenge is two-fold: first to model the asset cashflows; second, to determine an appropriate discount rate to apply to those cashflows using a discounted cashflow model. One way to address this is to split the discount rate into its individual components, namely a risk-free element and a risk premium.

Ultimately, outsourcing credit surveillance and valuations frees fund managers to focus on what they’re best at: informed investment decisions.

Ingo Wichelhaus is senior director, business management at Mount Street Group.