Loan Note: AI makes an advance into the credit world; initial thoughts on SEC private fund rules

They said it

“PE equity cheques don’t keep you safe if you haven’t done good underwriting on your own”

An anonymous direct lending source quoted in the Financial Times. The implication is that lenders should not be complacent about large equity cushions in deals.

First look

Advance of AI: the machines taking over cash functions (Source: Getty)

AI’s latest advance in the credit world
Equipped AI, a software and analytics provider for alternative asset managers, has this month introduced a new machine-learning system for cash reconciliation in direct lending and granular credit investing.

Routine as cash reconciliation may seem, much can go wrong, including manual input error, duplication of records or overcharging for servicing fees, as thousands of transactions have to be matched to bank records and invoices each month.

The new software designed to avoid such troubles is known as Minerva 2.0. In a statement, Equipped AI’s managing director, Stephen Connolly, described it as “a multi-tiered reconciliation model that systematically executes these cash reconciliation tasks with ease and highly impressive accuracy”.

Connolly said that a recent client case study looked at the average time spent on reconciliation per portfolio per month. It found that Minerva 2.0 can reduce that time from 16 hours to one, a 94 percent efficiency saving. Arithmetic indicates that if management has 12 portfolios to account for, it can save approximately 180 hours per month servicing that data by the adoption of the new tool.

Equipped AI, based in London, was formed within private equity firm AnaCap Financial Partners in 2017 before it spun off in 2021. Although its focus is in Europe, one of its oldest external clients is Amitra Capital, a wholly owned portfolio company of Canada’s CPPIB Credit Investments.

New SEC rules: could have been worse, but still bite 
After much anticipation, “SEC Wednesday” brought with it new, stricter rules for private fund managers around reporting and transparency. While the new era will bring its challenges, the rules are not as draconian as had been feared by some. Here’s our initial take, with more reflections to come once the implications are fully digested.

Senior debt going strong
Things are looking good for senior debt, on both a performance and default basis, according to the Lincoln International Senior Debt Index for the second quarter of this year.

The index, developed by Lincoln’s Valuations and Opinions group in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business, found senior debt yield reaching a record high of 11.7 percent at the end of June 2023, beating the previous high of 11.6 percent in the prior quarter.

The default rate, meanwhile, declined 30 percent compared with the first quarter, breaking a six-quarter trend of increased default rates in the direct lending market. Lincoln said it had seen over 450 loan amendments so far this year, representing around 20 percent of all the companies it tracks.

The firm said this indicated that borrowers and lenders were anticipating defaults caused by higher interest rates and were intervening to address the issue by amending loan documents. One third of these amendments had some kind of payment-in-kind interest, while 31 percent saw sponsors injecting additional equity.

The continuation/co-investment conundrum
When is a co-investment not a co-investment? As structures to hold assets for longer rise in popularity, the line between whether LPs should consider these transactions to be co-investments or continuation vehicles is becoming increasingly blurred. So how does an LP know the difference, and does it matter? This is a question affiliate title Private Equity International’s Side Letter recently put to a number of senior industry participants.

The bottom line is, if an asset is new to a GP, it’s a co-investment; if they already have exposure to the asset as part of the platform, it’s a secondaries transaction, a director at an advisory firm told Side Letter. When it comes to underwriting such deals, the risks aren’t that dissimilar, as investors need to look at alignment of interest, value creation strategy and credibility.

Deal volume for continuation funds involving one asset is likely to grow even further given the dearth of exits within private equity, meaning LPs will have a wealth of opportunities for this type of transaction, a senior managing director at an investment firm told PEI. Whether this tidal wave can deliver similar returns to traditional co-investments and therefore deserves to absorb some of the LP capital allocated to the latter, however, is not entirely clear.

“A lot of those deals have really attractive return opportunities by virtue of the expert… taking the second bite and recapitalising and giving the business new ways to grow through a bigger equity base,” the executive said. “Are those net returns going to end up being the same as no fee, no carry co-invest returns? All that still has yet to play itself [out].”


Fitch predicts deal pick-up
In the face of a possible recession, Fitch Ratings is expecting increased dealflow for alternative investment managers over the next 12 months.

With Fitch predicting a mild recession sometime between the end of 2023 and early 2024, senior director Dafina Dunmore said: “Distressed opportunities are expected to tick higher amid slowing economic growth and higher borrowing costs, while prospects for alternative credit are expected to emerge from the regional banking crisis.”

Dunmore added that the deal-doing environment was becoming more conducive as buyers and sellers become more aligned on the “new normal” for interest rates. A sluggish second quarter was characterised by economic uncertainty and divergent bid-ask spreads.

Fitch said dry powder was down 11 percent year-over-year at the end of June but that $516 billion was still available across alternatives for investment at “potentially more attractive valuations”. There remains solid investor appetite for private credit, infrastructure, secondaries and parts of real estate, while private equity “remains challenged” with extended fundraising cycles and reduced targets.

Shearer back at Proskauer
After 18 months at rival law firm White & Case, Jessica Shearer has returned to Proskauer as a partner in its private credit group. She will be based in Boston where she will advise private credit providers on acquisition financings, refinancings and restructurings.

Shearer specialises in financing types including first lien, second lien, secured and unsecured mezzanine, holdco, preferred equity and debtor-in-possession loans.

Proskauer’s private credit group represents private credit firms, business development companies and direct lending funds in connection with clubbed and syndicated credits, preferred equity, special situations and alternative investments.

Over the last five years, it has been involved in more than 1,000 deals for over 75 private credit clients across the US and Europe with an aggregate deal value of more than $260 billion.

LP watch

Institution: New Hampshire Retirement System
Headquarters: Concord, US
AUM: $10.7 billion

New Hampshire Retirement System has committed $50 million to Ares Pathfinder Fund II, a contact at the pension has confirmed.

This is a new manager for NHRS and enables the pension to diversify its private credit allocation, which is now approximately two-thirds senior direct lending.

The asset-backed Pathfinder Fund II has a target of $5 billion and is expected to have a final close in the first quarter of 2024.

Platinum subscribers may click here for the investor’s full profile, including key contacts, allocation strategy and fund investments.

Today’s letter was prepared by Andy Thomson with John Bakie, Christopher Faille and Robin Blumenthal contributing