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Preface
Operational risk is defined as the risk of losses stemming from inadequate or failed internal processes, people, and systems, or from external events[1]. This also includes legal risk, which is prevalent in document intensive asset classes such as private debt. While studies have shown that operational risk accounts for 50% of failures[2], such failures are likely to be even higher for private debt, as it has the highest risk across private fund types and requires careful management to mitigate exposure. This report seeks to identify the primary risk factors in private debt funds.
Fueled by investors searching for higher returns and by stock market volatility, private debt has grown tenfold over the past decade. The size, complexity, and growth trajectory of the private debt market is now approaching $1 trillion of Assets Under Management (AUM) with Compound Average Growth Rate (CAGR) of 11.4%[3]. The sheer size and growth increase pressure on fund managers to understand the risk factors and ensure counter measures to neutralize them.
Private debt risk factors
Risk Factor 1 – Asset class complexity
Private debt funds add a layer of complexity to traditional private investments. This includes trade confirmation and settlement with non-standard counterparties, illiquidity that creates valuation challenges, and asset servicing risk that is increased when future cash flows are uncertain. And, as strategies rotate through different stages of the economic cycle, complications with performing loans may exacerbate the service challenges.
Risk Factor 2 — Legal and document risk
Investment managers and GPs deal with a greater volume of industry-specific legal documents which can be a challenge for back-office staff not only to understand but also to process. In the loan market, even for transactions based on LMA standards, amendments are often required post-completion. In structured finance transactions, the volume and complexity of legal documentation is high given the bespoke nature of each deal, especially in private markets and warehouse structures.
Risk Factor 3 — Increasing complexity of fund structures
As credit fund managers expand their investments, they can easily outgrow their in-house resources or existing service providers when looking for opportunities across jurisdictions. The unique structures within each jurisdiction increase operational risk, especially if fund managers lack the local presence and regulatory permissions to provide services in regulated jurisdictions.
Risk Factor 4 – Lack of service provider integration
The number of jurisdictions, investment strategies, structures, and partners involved in debt funds also exposes asset managers to additional risk. In many cases, back and middle offices are forced to deal with multiple service providers to handle all their administrative needs, leaving them with disjointed workstreams, technology that isn’t integrated, and manual processes to fill in the gaps.
Risk Factor 5 — Increased competition and accelerating timelines
As private debt grows, increased competition, ever larger amounts of capital, and opportunistic investment strategies are accelerating deal timelines. Credit managers are finding it difficult to identify professionals with the prerequisite technical expertise, experience, and proven processes to maintain quality in this high volume, fast-paced environment.
Criteria for evaluating a private debt service provider
Criteria 1 — Experience
Given private debt investment’s propensity for higher operational risk, it’s critical to look for an experienced team that has this specific type of technical accounting expertise. It’s also important for them to be well-versed in evaluating the full range of legal documents. An experienced team will not only be able to anticipate and trouble-shoot the challenges around private debt investments but also offer solutions to counter them.
Criteria 2 — Processes, controls, and technology
In addition to the right experience, private debt funds need tailored processes, controls, and reporting tools that meet their requirements. All this must be underpinned by technology flexible enough to handle bespoke financial instruments and varied local market conventions. Finally, the systems should facilitate a look though the structure to meet your management, investor, and regulatory reporting requirements.
Criterial 3 — Comprehensive offerings and single source providers
Given the multi-jurisdictional nature of many debt fund structures–its propensity for multiple investment strategies and partners, and SPVs–a single source provider for fund services that includes legal entity management, and transactions services is even more critical. Where one service provider manages all facets of the transaction, the manager benefits from reduced operational risk streamlined workflows, integrated technology, enhanced reporting, and reduced time managing providers.
Criterial 4 – Integrated service model and culture fit
Often overlooked during commercial negotiations, a holistic approach to relationship management with a single point of contact saves significant management time and reduces operational risk. The complexities of debt funds with their multiple services, such as capital markets and other transaction services, are best served with a relationship manager that aligns the various experts within the organization to meet the client’s needs. This integrated service model is positioned to offer more innovative solutions, provide greater flexibility and depth, and be better able to scale as your business grows. Lastly, it’s important to consider the provider’s culture and how it fits with yours.
Conclusion
Is there an ideal service provider for complex credit strategies?
The not so simple answer is. . .sometimes. The ideal outsourced fund services partner goes far beyond the commoditised and functionalised minimum standards of the industry at large. All administrators should have experience and processes as well as controls and technology in place to support investments and structures. But, as experienced practitioners know, the test is at the margin. Here the manager is investing in, and the administrator is supporting, newer, more complex, or riskier asset classes, or new markets. How professional administrators deal with issues when something goes wrong is where the proof lies.
About CSC
CSC is a leading provider of specialized administration services. We support alternative asset managers across a range of fund strategies, capital markets participants in both public and private markets, and corporations and institutions requiring fiduciary and governance support. Clients entrust us with their fund administration, SPV management, loan agency, accounting requirements, and more across the United States, Europe, and Asia-Pacific. Commercial and agile in our thinking, our team brings innovative ideas to client interactions. With more than 120 years of independent ownership, we stand alone for long-term stability amid a turbulent marketplace.
For more information, contact robert.childs@cscgfm.com or visit cscgfm.com.
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About the author
Rob Childs is a business development director for CSC® based in London. With more than 25 years of international financial services experience across multiple functions and asset classes, Rob brings a consultative, solutions-focused approach to business development and relationship management. Rob is a graduate of London Business School where he received an executive MBA, specializing in finance and entrepreneurship.
[1] https://www.eba.europa.eu/regulation-and-policy/operational-risk
[2] Capco Institute White Paper Series: “Understanding and Mitigating Operational Risk in Hedge Fund Investments” (S. Feffer and C. Kundro) March 2003
[3] Preqin: https://www.preqin.com/insights/research/blogs/preqin-forecasts-alternative-aum-growth-of-9-8-percent-through-to-2025