Diversifying into Private Debt

Efforts by traditional and alternative asset managers to diversify both their client base and income sources have prompted several firms to embrace private debt strategies. According to Preqin, private debt raised $118 billion across 200 funds in 2020, bringing overall AUM (assets under management) to $976 billion (as of September 2020), increasing from $842 billion in December 2019. Investor appetite for private debt remains strong, with Preqin adding that 47% of institutions planned to boost their exposures to the asset class, while a further 40% intend to maintain investment levels.  

Although the pandemic has opened up a number of distressed debt and special situations opportunities for private debt firms, it is a strategy that is not without its risks, which managers – who are making the transition – need to be cognizant of. Firstly, the private debt market is very competitive. Preqin noted that - as of April 2021 - there are currently 592 funds in the market seeking to raise $300 billion from investors. Various macro headwinds could prove quite destabilising for private debt, too, with the prospect of rising inflation likely to dent investor appetite for fixed income products. Again, these are critical issues managers will need to address when moving into private debt.  

From an operations perspective, private debt is unique. Compared to a daily dealing trading strategy or private equity, the expertise required to navigate private debt markets is very different. An intricate understanding of credit is imperative, and a failure to hire suitably qualified people in-house could have longer-term repercussions. The same message is true of service providers. With fund manager hybridisation becoming more ubiquitous, firms need to think carefully about the type of vendors they engage with. Ultimately, a balance will need to be found between whether firms appoint a specialist administrator (most likely in addition to their existing administrator) who will be well-versed in complex private debt assets or a generalist who can handle multiple asset classes. What managers must not do is select a provider who has limited knowledge and experience in private debt.    

The same is true of technology infrastructure. Simply lifting trading or private equity systems and incorporating them into a private debt environment will not work. Instead, managers need to make significant changes to their infrastructure and add new systems in altogether if they are to succeed at running private debt portfolios properly. Although private asset managers have a reputation for being wedded to antiquated technologies, managers of private debt should use this time to automate their workflows and systems - as this can facilitate efficiencies, eliminate manual errors and mitigate risks.    

Competition for investor capital is high, meaning that institutions will be discerning. Although performance is obviously a primary driver behind any selection, investors will scrutinise managers’ operations, and deficiencies in automation, employee expertise and service provider quality could result in firms missing out on allocations. With more managers embracing private debt, they must develop robust operational systems if they are to attract meaningful capital.