According to Preqin, the size of the asset class grew to $1.3 trillion. It took 12 years to get to $1.2 trillion and projections are for the market to double in the next four years.
This significant growth in volume is beginning to take its toll on a traditionally manual process. When private equity firms venture into or expand private debt, new challenges are introduced to the back office impacting operations, administrative and regulatory functions. These challenges are due to the unique nature of private debt instruments compared to private equity, and include the aspects listed below.
Data and Systems integration
Most private equity systems are tailored to supporting fundraising, dealmaking, valuations and accounting. Private debt instruments require integrating data and systems to manage and track debt-specific metrics, such as coupon payments, interest rates, and maturity dates. This integration can be complex, particularly if the systems were not initially designed to handle debt instruments.
Currently, the standard practice is to track loans manually on Excel spreadsheets. The front office relies on this process to understand the future or current portfolio income, borrower risk, etc. There are a few solutions available for this, including:
Each of those solutions come with their own risks including data gathering challenges, manual error and application complexity.
Valuation and reporting
Valuing private debt investments is often more complex than valuing equity investments, especially when dealing with complex debt structures or illiquid debt securities. Private equity firms need to develop appropriate valuation methodologies and ensure accurate and transparent reporting to the front office investors, regulators and other stakeholders. The front office relies on this data to make investment and loan decisions. Understanding the future or current income of portfolio or borrower risk requires manual effort from the front office. This is not all dissimilar to the back-office environment before the introduction of systems like Investran.
Cash flow management
Private debt investments generate cash flows in the form of interest payments and principal repayments. Managing these cash flows and ensuring accurate allocation to investors or different funds can be a logistical challenge. Traditionally, these processes have been carried out using Excel spreadsheets, which, while versatile, are prone to errors and inefficiencies when handled manually. The reliance on manual entry can lead to delays, inaccuracies, and an overall increased risk.
Private equity firms that expand into private debt must effectively communicate their debt investment strategies to existing and potential investors. They need to address any questions or concerns related to the new asset class and demonstrate how they plan to manage both debt and equity investments successfully.
Talent acquisition and training
Hiring and retaining skilled professionals with expertise in private debt can be challenging, especially in regions or sectors with high demand for such talent. Professionals who can navigate the complexities of private loans help organizations stay compliant with regulations. Firms may need to invest in training programs to upskill existing staff or hire new talent to handle the specific demands of private debt investments.
Implementing a robust risk management framework to assess and mitigate credit risk associated with private debt investments is essential to protect capital and ensure compliance with regulatory standards. It allows investors to make informed decisions and potentially minimize losses. Private equity firms may need to adopt new risk assessment models and credit analysis techniques suitable for debt instruments.