Private debt: A fast-growing alternative asset class that demands specialist servicing

Private debt has rapidly emerged as a dominant force in the alternative asset space, gaining significant traction in both the US and Europe. This surge has been driven by a mix of macro-economic trends, shifting regulatory landscapes, and innovative strategies from asset managers. As the fastest-growing segment in alternatives, private debt is transforming the financial landscape, with Morgan Stanley estimating its value to have skyrocketed to $1.5 trillion by early 2024. In this article, CACEIS explores the key factors propelling private debt forward and what the future holds for this booming asset class.

Private debt has leapt to the forefront of the alternative asset sector in both the US and Europe fuelled by macro-economic factors, regulatory initiatives and enterprising asset managers. It is by far the fastest growing alternatives sector, which according to Morgan Stanley has seen a dramatic rise to an industry worth approximately $1.5 trillion at the start of 2024.

In the post-GFC economy, private debt was brought into the spotlight due to the combination of a dramatic fall in interest rates and prudential regulation that heavily restricted banks’ balance sheet lending ability, triggering an ensuing credit crisis. The crash in banks’ financing risk appetite saw resourceful asset managers cover the market shortfall with private capital at a range of investment horizons and with varied levels of risk appetite.

Private debt investors were attracted by the broad range of investment opportunities in terms of strategy, asset class and debt seniority which can be matched to their desired risk/return profile. Portfolio-diversifying investment opportunities, a reliable income stream (depending on the seniority), strong risk-adjusted yields, a potential liquidity for some investments, and the ability to attract retail capital through fund distribution platforms were all key factors in its rapid rise to the top of the alternatives charts.

While its most notable function is providing credit to privately-owned SMEs, private debt does however offer a range of investment strategies. One of the most common is deployed private debt assets which usually involves senior secured debt for mid-sized companies involved in M&A deals. Another is a Mezzanine debt strategy which involves debt below the senior level with an option to convert to equity in the case of default and which as a consequence offers a higher risk/return profile. A distressed debt strategy involves investing in and restructuring debt of companies in financial difficulty. A special situations strategy focusses on companies which show sound fundamentals but are currently facing unpredictable events such as a court case. In addition to company debt, private debt can also be deployed in infrastructure financing projects and real estate projects. Finally, private debt can be used in addition to venture capital strategies in private equity funds for related additional investments.

All the indicators for the private debt sector are positive and according to Morgan Stanley it could become a $2.8 trillion market by 2028 as banks continue to withdraw from the lending arena and investor appetite for inflation-beating returns remains high.

Turning to servicing needs for these private debt funds, we note that private debt-related interest calculations, supervision and monitoring of corporate events linked to the positions are time-consuming and complex. Performing such calculations internally for a high volume of loans and using an array of spreadsheets significantly raises the associated error risk. Furthermore, as investment strategies, reporting requirements and analysis demands increase in complexity, more managers are looking to automation of loan administration to free-up time, reduce error risk and focus on the core activity of investment decision-making.

There are a number of market-leading platforms for automating the administration and settlement of private debt, syndicated loans and many types of bond. Such platforms can provide overviews and data in real time across the entire book of loans and any underlying positions, thereby enabling managers to make better-informed investment decisions. Rapid access to data and reports is also a benefit when servicing LPs and fundraising is a key area of activity. Platforms enable managers to meet LPs’ increasing demands for transparent and timely information. In today’s competitive market, being in a position to satisfy LPs’ data requirements is of paramount importance.

State-of-the-art platforms require significant IT investments, and when combined with the development of internal systems and compliance with regulations, they can strain efficiency and profitability. Consequently, many private debt managers are outsourcing IT investments and operational development to asset servicing groups, which benefit from economies of scale. This allows them to spread technology and regulatory costs across a wide client base. These systems integrate with the servicer’s administration and custody platforms for seamless reporting and analytics, and managers can also establish direct data flows to their systems. Additionally, common operational methods across the asset servicer’s network support international sales strategies and provide consistent servicing across various jurisdictions.

Staffing is another critical concern for private debt managers, especially in today’s competitive market. Attracting and retaining skilled operational staff who understand the complex needs of private debt management is essential. Recruitment issues can hinder timely deal analysis, making outsourcing to asset servicing groups valuable. These groups offer experienced staff with specialised loan servicing expertise and foster long-term client relationships. With a professional team supporting their business, managers can reduce time to market and better meet the demands of investors.

All in all, the private debt market offers many opportunities for managers contemplating stepping into the market as traditional banks leave, and with the support of powerful data platforms tools, expert loan administrators and a team of dedicated professionals, the outsourcing route is an appealing prospect.