Private Credit Investing: Exploring Private Credit Architecture and Credit Quality

Growth of Private Credit

The private credit market has grown significantly recently and appears poised to continue this expansion. Private debt as an asset class has increased to nearly $2 trillion by the end of 2023 and has an addressable market of more than $30 trillion in the United States, according to research performed by McKinsey.¹ Demand for this asset class is expected to be met by the proliferation of private credit vehicles managed by an ecosystem that includes private equity managers, hedge funds, family offices, and other alternate lending platforms. Investors such as pension plans, insurance companies, family offices, other institutional investors, and retail investors have increasingly shown interest in diversifying into private credit. For borrowers, private credit is a compelling option due to the ability to obtain private credit financing faster than traditional banks. Additionally, private credit products can often be more tailored to a borrower’s specific needs.

Private Credit Funds

Private credit has long been appreciated for its efficiency in pooling capital for investment purposes. Whereas a traditional bank must operate its credit strategy within the parameters of regulatory capital requirements and risk management at the overall entity level, a private credit fund or other private credit vehicle typically has more maneuverability in determining its size and risk profile and identifying which type of borrower, lending gap, or industry sector it can best service. A private credit fund manager seeks investors interested in the specific strategy designated for the private credit vehicle and marketed through its private placement memorandum and other offering materials. These vehicles may generally offer subscriptions and allow redemptions on a monthly or quarterly basis, and some may provide periodic distributions of investment income for investors who elect. The results of the investment strategy are generally reported to investors through the issuance of quarterly statements and annual audited financial statements. When properly implemented, this efficient capital structure can provide maneuverability in acting quickly on arbitrage opportunities in the credit markets.

For asset managers and institutional investors looking for diversification through private credit funds, credit has a different risk profile than other asset classes. Debt is a more liquid asset class than a typical private equity investment in a portfolio company, as investors in debt are generally repaid before equity investors. At maturity, investors in debt can typically expect repayment from available sources, such as net cash flows from operations or refinancings with third parties. This contrasts with an equity investment in a portfolio company where an exit depends on liquidity events such as an initial public offering, sale, or recapitalization. A company can also issue convertible debt, which the holder can convert into equity in the future, depending on contractual terms. Convertible debt provides another option for investors to act in their economic best interest and maximize their return. Another feature of credit is that debt investments can limit investor exposure to future changes in benchmark interest rates by extending floating rate notes. Credit quality and the performance of borrowers’ operations to support the repayment obligations of debt continue to be vital to the success of any private credit strategy.

From a reporting perspective, a significant benefit of private credit funds is the ability to report at fair value in accordance with generally accepted accounting principles (GAAP) if qualifying as an investment company.² Fair value reporting is crucial for certain investors, such as pension plans and other institutional investors, who can readily benchmark the performance of this asset class against other investments in their portfolio.

Architecture Around Private Credit

It is essential that managers of private credit funds build the infrastructure and capabilities to support the monitoring of credit quality.

A private credit fund reporting its loan portfolio at fair value to investors may use an income approach model such as a discounted cash flow. This model discounts future contractual principal and interest cash flows, generally using a discount rate for the current risk-free rate plus a spread for the borrower’s credit risk. This credit risk input represents the risk of the borrower’s ability to repay the loan under its contractual terms and can significantly impact fair value. A loan with a borrower with deteriorating credit quality would generally result in a higher spread, negatively impacting fair value. As such, the monitoring of credit quality plays a vital role for private credit funds.

Banking institutions, a highly regulated industry, have established robust internal methodologies around monitoring the credit quality of their loan portfolios under the prescriptive accounting guidance relevant to financial institutions. The Office of the Comptroller of the Currency Comptroller’s Handbook states the expectation that banks “rate credit risk based on the borrower’s expected performance, i.e. the likelihood that the borrower will be able to service its obligations in accordance with the terms. Payment performance is a future event; therefore, examiners’ credit analyses will focus primarily on the borrower’s ability to meet its future debt service obligations. Generally, a borrower’s expected performance is based on the borrower’s financial strength as reflected by its historical and projected balance sheet and income statement proportions, its performance, and its future prospects in light of conditions that may occur during the term of the loan.”³

While private credit funds report under different standards (generally fair value, if an investment company) than banking institutions, it is vital that the credit quality of the loan portfolio be continually monitored. Fund managers should establish methodologies and controls to ensure that loans reported at fair value reflect any deterioration or improvement in credit quality.

Best Practices Private Credit Funds Can Apply

While this listing is not all-inclusive, below are certain practices implemented by banks that managers of private credit funds should consider concerning monitoring credit quality:

Borrower Financial Statements

Fund managers should implement quarterly or other periodic reporting requirements for commercial borrowers. Fund managers should monitor quarterly reporting, including borrower balance sheets and income statements, revenue growth rates, profit margins, development progress, liquidity, and other credit quality indicators of borrowers. This information is essential to understanding borrower uses of funds, monitoring the reasonableness of financial projections to support repayment of loans, and identifying credit weaknesses in the loan portfolio. Written procedures regarding this monitoring mechanism should be established and followed regularly.

Secondary Sources of Repayment

In assessing the strength of credit quality, fund managers should also consider secondary sources of repayment, such as guarantees or collateral. These credit enhancements impact credit quality, as they provide some protection against non-repayment when a borrower defaults. When relevant, guarantor strength or collateral can significantly impact credit quality. The financial statements of the guarantor and summaries on the quality of available collateral, such as real estate appraisals, inventory obsolescence analyses, accounts receivable collectability assessments, and uncalled commitments, when relevant, should be continually requested and monitored.

Management and Industry

The management of a borrower entity is important to understand. Any changes to management should be contemplated in the context of their ability to execute plans that support the repayment of debt. Additionally, conditions such as volatility, competition, and technological change impacting the borrower’s industry are a critical qualitative consideration of credit quality.

Credit Write-Ups

Fund managers should regularly monitor credit quality for both operational and financial reporting purposes. An efficient way to monitor the credit quality of borrowers is through regular credit write-ups, a practice applied at banks. Documentation is key to accruing knowledge on the credit portfolio held. Loan officers for banks prepare credit write-ups that inform management about asset quality and weaknesses in the credit portfolio. The Comptroller’s Handbook indicates these write-ups “describe specific loans whose collectability is questionable and which, if not collected, would have a significant effect”³ on earnings or capital. “Loan write-ups assist bank management and board members by clearly communicating the reasons for credit classifications and credit administration deficiencies.”³ While such write-ups are required by regulators of banks, not private credit funds, fund managers should consider implementing similar procedures to regularly monitor their loan portfolios. Fund managers can use these credit write-ups to manage their credit portfolio, assess when and which loans require supervision by workout specialists, and determine when secondary sources of repayment should be contemplated. Additionally, these credit write-ups can be a source used by fund managers to support the inputs used for valuations provided to investors through audited financial statements.

Delinquency Reporting

Loan information for commercial borrowers is generally not readily automated. However, fund managers should consider standardizing reporting functions for smaller, homogenous loans. For example, delinquency reporting, such as 30 days, 60 days, or 90 days past due, is an example of standardized reporting that is helpful in assessing the credit quality of a homogenous loan portfolio for operational and financial reporting purposes. A quantitative report regarding all borrower delinquencies should be considered in regular meetings to ensure consistency in applying the impact to valuations and avoid management bias.

Regular Meetings

Loan officers for banks hold regular quarterly meetings to assess credit quality. Reviews are generally performed on a pooled basis for smaller homogenous loans or on an individual basis for material loans above established thresholds. Credit quality indicators may be identified through delinquencies and review of financial statements or projections for wherewithal to pay. Fund managers should consider establishing regular meetings for updates in credit quality and integration into the valuation methodology of such loans. For example, credit quality procedures should be aligned with identifying the appropriate spread to use in the discount rate for fair value or considering secondary sources of repayment. A private credit fund may use internal or external expertise to prepare fair value models for its debt portfolio. Regardless, management is responsible for reviewing and approving the inputs utilized and the fair value conclusion. Keeping an established line of communication between management, the valuation team, and individual lending teams will provide for an efficient and effective review by management of such inputs and the fair value conclusion required for investor reporting.

As the private credit market continues to expand, managers of private credit should prioritize building the infrastructure and capabilities to support the monitoring of credit quality. Establishing such a framework will allow managers to scale their efforts to take advantage of the growing opportunities in the private credit market.

For more information regarding private credit, contact John Guerrieri or Marcum’s Alternative Investment Group practice.

Sources

1. https://www.mckinsey.com/industries/private-capital/our-insights/the-next-era-of-private-credit
2. Before raising capital from investors, managers and fund sponsors need to understand the ramifications of how the entity is marketed and presented to current and potential investors. An investment company, as defined by FASB Accounting Standards Codification Topic 946, has the benefit of reporting its assets and liabilities (net asset value) at fair value. This attribute is important for many institutional investors. If an entity believes it is an investment company, its design, business purpose, and how it holds itself out to investors should be consistent with those of an investment company. An investment company’s business purpose should be primarily capital appreciation, investment income, or both. Among other considerations, the significance of the income generated from the entity’s origination and syndication of loans compared to the income generated through capital appreciation, investment income, or both is an essential factor for entities to consider. Generally, the fee income generated as part of loan origination and syndication of loans should not be significant compared to the income generated through capital appreciation, investment income, or both for investment companies. There are additional steps for consideration. Please reach out to the author with any questions. Classification as an investment company significantly impacts reporting requirements, and time should be spent to clearly establish this conclusion at the onset of an entity’s operations, considering a fund’s purpose and investor expectations.
3. https://www2.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/rating-credit-risk/index-rating-credit-risk.html