Apples and oranges

The breadth and diversity of private credit strategies are part of its appeal, but these qualities also act as a constraining factor as the asset class seeks to break into the mainstream.

Investing in a private debt fund is a much more complex undertaking than buying a more liquid instrument, particularly in Europe. Investors must consider a variety of risks, while managing this type of transaction is markedly different and more operationally cumbersome than other asset classes.

For private debt to gain more traction with investors, GPs are having to do more to help traditional LPs measure the performance they deliver and therefore increase allocations to the asset class.

“Performance measurement of private credit is a minefield, because there is no single approach,” according to Sanjay Mistry, director of private debt at investment consultancy Mercer. “The sheer breadth of funds means some strategies are too young or too illiquid to gain any meaningful performance data.”

David Hunter, head of pension fund coverage at placement agent First Avenue, concurs: “Compared to liquid funds, private credit presents a number of challenges when it comes to performance measurement. For example some manager strategies and funds are relatively new, and not fully exited, so it’s hard to get hold of a wholly independent track record. It’s more common to have Funds 1 or maybe 2, but there are generally fewer Funds 4s and 5s than with private equity.”

That’s not the case across the board, however. Senior debt and mezzanine funds have 15 to 20 years of investment history and provide a good peer group when evaluating which mid-market direct lending strategy to back. Contrast that with senior secured infrastructure bonds where there are no fund exits, making it impossible to show fund-level performance. 

That doesn’t mean it’s impossible to evaluate performance altogether, however, but it does demand an exhaustive, bespoke approach. The only way to get meaningful data is to drill down through the fund structure and assess the individual loans on a deal-by-deal basis, says Daniel Schmidt, chief executive of CEPRES, which holds data on 260 private debt funds and more than 10000 private debt loans. 

“While debt infrastructure funds are new, some private equity investors were investing in infrastructure deals in the 1980s so it is possible to look at the individual deals,” he says. 

Credit fund performance is normally linked to economic conditions, making it hard to compare, for example, a loan’s performance between 1990 and 1994 with one between 1999 and 2004. But Schmidt argues that credit cycles follow patterns and it is possible to adjust for similar macro-economic environments.

When it comes to asset allocation by investors, the range of private credit funds means that some allocations are made from a private equity bucket and others from a fixed income one. The problem for GPs is that these two constituencies are poles apart when it comes to reporting requirements and decision-making processes.

With many alternatives-savvy investors, credit decisions tend to be made by private equity teams, rather than their fixed income counterparts, so the metrics they apply are the same as apply to private equity – IRR and multiples.

For alternatives managers like these, private debt presents a challenge to their private equity-tinted view of the world, where the return is ’king’ and the upside can theoretically be unlimited. “Unlike private equity, with private credit the upside is capped, so investors have to focus on the downside, on the risk as well as the return,” adds Mistry.

That requires exhaustive assessment of credit risk across a portfolio, by looking at default and recovery rates on an individual deal basis. An investor who selects the credit fund which generates the highest return is also likely to find it has the highest level of risk and potential downside. 

“Large traditional LPs look more at the risk side of the equation. They have risk departments, which are staffed by people from more traditional backgrounds in bonds and stocks, rather than alternative investments,” says Schmidt.

While alternative managers will look across the lifetime of a deal, risk managers will want annual numbers on defaults and current interest rates.

CEPRES enables GPs to input their own performance confidentially, so they can benchmark performance against other funds – but they do not know which funds. This confidentiality has given GPs the confidence to be more transparent and Mistry says transparency is less of an issue than some investors may think, provided they are educated to engage in a more active dialogue to understand performance. Or as Citigroup put it in a recent note to investors, “Once you get transparency, transparency leads to confidence and confidence leads to investors re-engaging their cash.”

“GPs are quite open and provide visibility on performance because they know they have to in order to attract [further] investment,” said Mistry. “The exception to this might be a distressed debt fund, where the managers might not want to disclose their positions for fear of harming their strategy.”

Transparency is an ongoing quest. Some LPs request data on a monthly basis, involving a much more detailed report listing every debt position that the fund holds, including duration, coupon rates, information on the hedging activities that the fund has taken.
GPs are also careful to avoid perceived conflicts of interests when valuing funds. One debt manager explained that it conducts all valuation functions for its clients in-house using functional teams that are separate from the portfolio management team, and valuations are signed off by a qualified director on the manager’s board of directors. Where applicable, managers value and measure investments on a consistent basis in accordance with applicable laws and regulations, as well as globally recognised and accepted accounting standards. For unlisted debt securities, the standard adopted is the International Financial Reporting Standard 9.

Many traditional managers suffer from risk-aversion to private credit, because of its typically illiquid nature, lack of timely reporting and other metrics that they associate with the investment process. Often, any perceived uncertainty is enough to persuade them not to proceed with an investment and their level of risk appetite may mean that private credit remains too rich for their risk palate. “That means they’ll miss out on the best returns now, preferring to wait until the market is more developed, by which time the best returns may have gone,” said Mistry. And besides, the big decisions over asset allocation are made for them by risk committee who may simply regard private credit as an asset class that it too immature. 

Schmidt adds: “The private credit market is being constrained because many LPs are not set up to handle it. For private credit to match the banking market, it needs to gain more allocations. At the moment, the bottleneck is the risk teams, who need more timely information to approve the allocation decisions that allow the LPs to invest.”

The challenge that GPs face is that in the current climate, LPs have fewer resources but demand greater data and more and more analysis.