Investment banks such as Goldman Sachs, asset managers and insurance companies are raising money from investors to create private credit funds. They then issue private loans or buy private debt from companies. Pension funds encouraged by the UK government are looking to invest in private markets, including private credit. According to the Financial Times, the private credit market is expected to grow to $300 billion from about $130 billion currently.
For the private debt/loan market, there is poor access to balance sheet data, and therefore, credit rating agencies do not rate the debt. However, it can fall into the investment grade category, but typically, it would be classified as high yield (junk bonds).
Private debt teams then employ several analysts to scrutinise the balance and accounts of the companies issuing private debt or taking out private loans. The portfolio managers will have specific knowledge of a particular industry sector or region (e.g. emerging markets).
Fund managers usually visit the company that has issued the debt or taken out the loan on a regular basis to get a good picture of the health of the business. The fund manager typically produces a valuation of the debt/loan and compares it to other debt/loans issued/taken out by similar companies (public or private) to see if it is cheap or expensive. This can be complex because the debt usually comes with kickers such as options, warrants and callable features, which can have a complicated payoff.
Data on private debt is not readily available, so static data on debt cannot be downloaded from systems such as Refinitiv or Bloomberg. Therefore, it must be manually set up on portfolio management systems. The complex kickers are often exceedingly difficult to model and value on most systems.
The major issue is the valuation of the debt/loan. A credit spread to a government curve must be determined based on the assessment of the risk of a default. The estimated risk of default will be different between the portfolio manager’s point of view and an independent valuation from, say, the big four or other independent valuation agents. The portfolio manager will take a specific view of each issuer based on their in-depth knowledge, while the external valuer usually compares to similar issuers to arrive at the default risk. This can be a point of contention between the portfolio managers and the team responsible for valuations within an asset manager. A robust valuation governance structure must be put in place. Valuations of the debt and loans, because of the intense manual process, will only be carried out on a quarterly basis. However, they are often subject to ad hoc valuations if there is some news from the company that could adversely affect its ability to meet its debt/loan obligations. All this must be clearly set out in the fund’s valuation policy and the legal documents issued to potential investors in any private credit fund or funds that contain private debt/loans.
The whole end-to-end process for private debt/loans held in Private Credit funds is very manual and intensive. A good operating model that reflects this must be designed for the business, which has a strong independent governance of the valuations of the instruments held within the fund.
Davies has considerable experience in establishing private credit funds for asset managers. This covers the design of the governance of the fund, its operating model, and the selection of external independent valuation agents. If you are looking at establishing a private credit fund, we would be happy to share our experiences in this space with you.
