How to keep ahead of the game

As we near the end of the current cycle, the maturing private debt industry hits a crucial stage in its evolution. Cesar Estrada, State Street’s head of product management for private equity and real assets fund services, explains how fund services will play a part.

This article is sponsored by State Street and first appeared in the Fund Services Report special supplement

What trends are you seeing with your clients in terms of investment strategy?

This relatively young private market asset class continues to display a significant amount of activity and creativity across not only investment strategy, but also fund structures, institutional investor behaviour and distribution channels. As it relates to investment

Cesar Estrada

strategy, the broad theme we are seeing is the private credit investment universe continues to expand. Also, the specialisation of managers is starting to become much more apparent. Direct lending to mid-market companies tends to be the most popular investment strategy, but even as that continues to evolve and grow, different fund managers are subdividing it into tiers, such as the lower and upper mid-market.

Sponsored deals continue to be the bulk of what we see in private credit. Non-sponsored deals seem to be harder to originate, but they’re happening. There are other forms of private credit with operational challenges that we’re starting to see more of too. We now have real estate and infrastructure credit starting to pop up through some of the big real estate managers. We’re also seeing distressed debt and all sorts of speciality financing as well.

Do you feel the industry is sufficiently prepared for a downturn?

We don’t claim to have a crystal ball as to when there will be a downturn, but certainly a downturn must happen as everything operates in cycles. We’ve been working with private credit managers for many years, even before the financial crisis, and we believe they’re here for the long-term. There’s been a gradual shift over time into the more senior rungs of the capital stack in anticipation of a downturn.

When we look at what happened in the financial crisis, and we look at the US mid-market, for example, the default rates of mid-market private companies were relatively lower versus other areas. That’s not to say a downturn won’t impact these investments, but our clients are creative, and work to evolve their investment strategy to take advantage of opportunities the next downturn may bring.

“Managers want to engage with fund administrators differently and in a way that resonates for them”

Is the increasing diversity and innovation among private debt managers creating new challenges for fund services?

It does in several ways. As private credit branches out from being predominantly corporate debt into real estate, infrastructure and other areas, managers that have a legacy in these asset classes want to differentiate. They want to engage with fund administrators differently and in a way that resonates for them. They want to see that we understand the underlying assets and can serve their needs. At its core, the fund administration offering is similar across all private market asset classes, but the underlying assets and the new ways we keep track of those investments can carry operational and accounting challenges that need to be addressed.

Are clients more comfortable with outsourcing more responsibilities and are fund services providers expanding their remit?

One thing some of our most successful clients are doing to fully take advantage of outsourcing is associated with how they are leveraging their origination and underwriting platform more broadly across different product types. Some time ago, a manager would have had to pass on a $500 million deal or do it as a club deal, adding complexity. Today, they might do it themselves and then allocate it to different types of funds all under their brand.

In other words, a successful private credit manager who launched a series of private funds might now be launching a specialised fund with certain requirements. While some of those structures may be familiar to the manager – the LP structure, the carried interest and the waterfalls – something like a BDC, an open-ended fund, a Luxembourg fund or a new wealth management distribution channel could be unfamiliar. It might be new territory and have an additional requirement. We enable them to continue growing at a fast pace without investing in new infrastructure on their side.

What qualities are the private credit managers now looking for in a fund administrator?

I think clients are looking for a more streamlined model that allows them to not only have the fund administration, accounting and loan services – ideally with a single party – but also the banking, the custody and the financing.

As we’ve seen with the growth of our private credit book of business, I think we’ve become more intelligent about how we offer value to our clients. Banking is synergistic with accounting given the volume of transactional activity in a private credit portfolio and the need to sort through all of this, reconcile it and tag it for performance on a deal-level basis. Additionally, we’re using our balance sheet to support key clients with their financing needs, such as subscription lines of credit and, more recently, asset-level financing.

How has the way fund services providers work with investors evolved?

Over the last few years, institutional investors have grown from investing in third-party funds, or funds-of-funds, to doing co-investments and funds-of-one. The degree of sophistication keeps growing in private credit. What we’ve seen is driven by significant appetite for exposure to North American private credit.

“Over the last few years, institutional investors have grown from investing in third-party funds, or funds-of-funds, to doing co-investments and funds-of-one”

We have several very large and significant non-US institutional investors accessing this market in different ways. Some have, or are in the process of building, their own investment teams. What they’re looking for from State Street is for us to be their infrastructure so they can focus on building their investment and origination team without having to focus on building an operation.

Recently we have seen several large investors taking a sophisticated approach by creating multi-manager fund structures to quickly deploy their capital as they try to catch up on allocations to private credit. They’ll engage with different managers and create complex fund structures with different sleeves with different managers. What they want from us is to support those structures and deal with reporting, as well as work with their various fund managers and gatekeepers.

What role do you think technology will play in the future of fund services?

It’s a long journey. Someone at a recent blockchain conference said something that resonated with me: when you’re in the thick of technological change it seems more evolutionary; but when you look back eight years from now, it will look much more disruptive. The ability to produce, store and deliver data has always been important in the private credit space. The 24/7 availability of fund investment and investor data in today’s global market is increasingly important to our managers and clients regardless of their location.

They’re looking for more, including the ability to aggregate and produce data from various sources in a very easy, digestible manner. We have clients where we automate all their records and bring them together on a deal-by-deal cashflow basis with numerous data points so they can easily slice and dice performance data for multiple uses. As the industry evolves, we’ll continue to develop increasingly sophisticated reporting solutions for our clients.

Does this make cybersecurity a growing concern?

For us, as a regulated large financial institution, it’s critical to have a long-term risk-based strategy to safeguard our client’s information. We have extended our cyber and information security to our global organisation and have aligned our operations – not only our internal subsidiaries but also our joint ventures – around a common framework. We continue to build our next generation of cybersecurity capabilities to enable secure business growth as we invest in people, processes and technology to protect our client’s data.