The emergence of private debt funds in Europe is one of the more positive consequences of the collapse of Lehman Brothers five years ago. Often launched by former bankers with a strong background in fixed income trading, these funds have a hawkish view of financial risk management.
This stems from the fact that – as well as wanting to protect their reputations and their investors’ money – many of the new breed of debt investors have learned hard lessons from working in big investment banks in the years running up to and following the global financial crisis.
Heath Forusz, head of commercial real estate debt at Tyndaris, and the former head of commercial real estate capital markets for EMEA at Deutsche Bank, says: “Too often during the crisis, risk management systems were found wanting because they were not unified, making it difficult to calculate true exposure. We have learned the importance of developing proper risk systems from our experience managing multiple billions of risk on banks’ balance sheets through the crisis.”
Forusz was among a number of former Deutsche Bank employees who worked within its highly successful CMBS and CRE operations, which was deemed to have had a ‘good crisis’.
Nevertheless, there are lessons from working in big global firms, where systems are often spread across the organisation and provide no central access.
Start-up debt funds have the opportunity to get risk management right in a way that investment banks, with their sprawling divisions and mixture of technology platforms do not. They also know it is crucial if they are to attract investors in the first place, and make sound investments in another. While traditional bank lenders had systems built around the assumption that the debt they were underwriting would be syndicated, debt funds must have the right processes to take a longer-term view.
“With debt investing it is about identifying the risks and building-in the appropriate structural protections prior to making an investment,” Forusz continues. “Making the best investment decisions is about having the right processes and risk management systems in place. Having those systems in-place ensure the effective monitoring of the investment.”
“During the last boom, when conditions were benign and credit widely available, many firms adopted a high level, top down view of risk management especially for granular portfolios. That is no longer sufficient in a more cautious environment where capital is more scarce.”
Maddox advocates a ‘bottom-up’ approach to risk management which deals with each investment on a much more granular level and enables investors to mitigate risk during the bidding process for portfolios of residential mortgage assets. And says Maddox, as real estate investors stretch outside of their comfort zone and invest more in residential mortgages, they need partners to help them understand the asset they are dealing with.
The relatively small if growing size of the private debt market in Europe means that a granular approach to financial risk management is both necessary and possible. In the current cautious climate, underwriting debt packages for some mid-market deals is typically taking six months, where previously they would take three. This is a good thing, according to industry professionals, and it’s down to the increased rigor of non-bank lenders.
Olivier Berment, head of private debt at French alternatives group AXA Private Equity, says: “Risk management is in our DNA and we have applied our expertise in risk management from our private equity to our debt business. We want to be seen as a partner rather than simply a lender.” As such, AXA Private Equity has a role as a board observer on every company it invests in. It also double-checks its investments with AXA Private Equity’s independent valuation committee.
The approach of Berment’s team and the firm’s private debt model has also been shaped by the financial crisis. In March, Berment’s team arranged a €220 million unitranche facility for the acquisition of IPH by PAI Partners from Investcorp and Berment says the Unitranche approach is in keeping with risk management best practice.
“A lesson financial sponsors learned from the financial crisis is that it is not good to manage numerous lenders. Being the sole lender on a deal is good for risk management for all stakeholders – management, the sponsor and the lender.” It makes it easier for the lender to change documentation as much as it favours the borrower in getting quick decisions made when it comes to increasing capital expenditure.
One advantage of being a start-up debt fund is that it does not suffer the problems of legacy systems affecting big investment banks, making the importance of having scalable financial risk management systems from the outset essential because it means a debt investor can keep track of its exposure on a granular level even when it is managing many tens of billions of euros several years down the line. Forusz added: “You have to build the proper risk management system and processes from day one so it is engrained into the culture. If you try and build later or as you go along, it becomes exponentially harder to implement.”
Investing in technology and risk management processes is costly but debt professionals argue it is essential to capturing alpha – and avoiding disaster. Having robust processes to judge credit risk on an individual level is essential, and the message from debt funds is that the more granularity, the better. That starts with developing a relationship with the management team of the company a fund is thinking of investing in, to having an in-depth knowledge of the company’s operations, the sector it operates in and its geographic reach.
Berment adds: “One of the most important tools in risk management is applying the right leverage ratio at the point of entry, because that defines the risk level.”
Following the financial crisis, some private equity firms began using derivatives to hedge currency risk and lock in gains but this practice is far from widespread. When raising a fund, managers argue the investor is aware of the currency that the fund is denominated in and that managing currency risk within a portfolio is not its raison d’etre. But as debt funds are sourced from an investor base that is increasingly global, some funds do manage redenomination risk.
When raising its $7.1bn AXA Secondary Fund V last year for example, AXA Private Equity received investments in sterling and euros as well as dollars, and has a dedicated hedging team to handle denomination risk. Although it wasn’t a debt fund per se, the approach is applicable to the group’s future debt vehicles. But that does not extend into the active management of currency fluctuations because of the buy-and-hold nature of the fund.
Acenden offers ongoing analytics for investors, which includes the scope for the use of derivatives in hedging.
Getting financial risk management right is one of the most fundamental areas for debt funds to address, although there are other areas too, such as operational risk management, which comprises the risk of losses stemming from inadequate or failed internal processes, people and systems or from external events. Operational risk management is at the top of big banks’ agendas as they seek to meet the raft of new regulatory requirements in the wake of Lehman’s collapse and the ensuing financial crisis, requiring them to hold more capital against assets and boost their level of equity to meet a new percent leverage ratio.
It also applies to ‘conduct’ risk, a phenomenon that has been on the rise since the financial crisis, where fraudulent or questionable activities have cost investors. The onus is on investors in funds to demand transparency over management responsibilities and investments before making a decision to invest in a fund.
Indeed investors, as well as managers, are becoming much more proactive in terms of risk management. Many LPs now conduct risk analysis not just of the fund for which the GP is soliciting commitments, but the firm as a whole. This is particularly true of private equity firms, but is also applicable to their debt counterpart. For the larger multi-asset managers, many of whom do both, it’s even more relevant to LPs because what occurs in one part of the business may affect other areas (particularly if the management entity is listed).
In creating a risk profile for the entire firm, one must analyze the distribution of returns the firm has generated over a given time period. This type of research is done by GPs and LPs alike, but more typically to evaluate the return potential of a future fund, and not necessarily firm-wide risk, adds one investor who spoke to Private Debt Investor.
Recent research from academic Oliver Gottschalg of HEC Business School has paved the way for alternative asset managers and their investors to conduct a more effective risk profile analysis of firms by using a profit distributions method.
But by comparing the cumulative profits generated by a certain sub-set of the portfolio (to the size of the sub-set) you can create a risk profile for a private equity firm, according to Gottschalg.
What you end up with is plotting the percentage of a fund’s investments on the x-axis and the percentage of profits from the fund on the y-axis – known as the PERACS Risk Curve. In other words, you can measure for example to what extent the worst 20 percent of all deals are responsible for contributing less than 20 percent of the profits of a firm.
LPs of course differ in their preference for different shapes of the risk curve, and the modelling for many types of debt fund will look very different to a typical buyout fund. Even across the debt spectrum though, there is a very wide distribution of risk / return profiles. Some limited partners may favour fund managers that appear to systematically generate moderate levels of return with little loss-making deals, whereas others may want to invest in managers who find big hits and may tolerate some losses at the same time.
That sort of analysis is relatively affordable for an LP, but from a GP’s standpoint, investment in risk management tools and indeed personnel can seem expensive.
Some funds regard the cost of installing bespoke operational and financial risk management systems as prohibitive, but in the post-crisis world, risk management is becoming a welcome barrier to entry. Different funds have different needs depending on the type of assets they invest in and the length of time they are holding them for. But any risk management system must be able to run future scenarios, rather than simply focusing on the state of the market at the time an investment is made.
Managers can also take out some fairly esoteric types of insurance policy designed to mitigate risks. These include key man disability insurance (it’s more typical to insure against the death of a key man, but disability is statistically more likely) and political insurance (particularly relevant for emerging markets-focused funds).
For most firms however, the key risks will be at an investment level. Successfully managing those differentiates the good managers from bad. The more forensic a firm’s approach to risk, the higher the probability of it delivering strong returns.
One of the lessons Forusz learned from the crisis is that investment decisions were not made with a long-term view, so that when they ran into trouble, it was hard to identify true exposure. He adds: “We don’t just take the 20,000 foot view, but use a ground up approach getting granular with the data and having the right systems in place to capture and analyse that data to identify upfront and ongoing risk.” It’s a prudent approach, and one which is becoming, thankfully, increasingly prevalent.