When selecting a private debt manager, credit risk management expertise is one of the key characteristics you should look for.
Credit risk, at its core, is the risk that a counterparty, also referred to as a “borrower”, will default on its payment or other obligations to its lenders, the most important of which being that the borrower will be unable to make interest and principal payments owed to lenders. Loss given default is the amount, net of recovery, from the collection of cash or disposition of assets subsequent to a default event to which the lender has a claim. Credit risk, or risk of default, is inevitable when investing in credit markets and can be exacerbated by various credit events: rising bankruptcy levels in the economy, downgrade by a credit rating agency, or corporate events such as mergers or spinoffs.
Here are 3 key things to understand when selecting a private debt manager:
1. Portfolio Credit Risk Management
If you are investing in a diversified pool of private loans (compared to deal-by-deal investments), you should understand how credit risk is managed at the portfolio level. Top-performing private debt managers have formal processes for managing credit risk and should be willing to disclose those processes to their investors.
It might also be useful to familiarize yourself with measures used by the manager to monitor credit risk exposure. Portfolio loan to value, historical default rates, covenant compliance levels, and recovery rate in the event of default are common measures applicable to private debt markets. Such measures help to understand credit risk exposure in any given period and allow investors to focus on the overall portfolio performance with attribution to individual line exposures.
2. Credit Events Expertise
Credit events are an inevitable part of private debt landscape, and for that reason, top-line credit managers will have extensive experience in managing workouts with companies in financial distress. A forbearance agreement is a mutually agreed contract between a lender and a borrower created with the purpose of re-setting the terms of the existing loan. Forbearance agreements establish new debt service requirements for the borrower that are both acceptable to the lender and allow the borrower to remain solvent and usually include both additional fees and enhanced reporting requirements for the borrower.
Another important question to ask your credit manager is: “How much experience do you have managing default events?” It is important to note that values of assets auctioned in a forced sale may be lower than a normal disposition target. A manager’s experience and expertise working through financial distress is critical to mitigating losses when default events occur.
3. Offsets for Credit Risk
Naturally, borrowers have more information about their businesses than lenders. To offset such risk, lenders will demand priority claims on the borrower’s assets if interest or principal payments are missed and private debt managers also may make allocations to credit reserves to set aside a portion of current returns to offset the cost of potential default events within their portfolio.
Collateral is the borrowers’ assets that can be pledged as a security to protect the loan. Asset-based lenders, for example, will lend against the value of the balance sheet assets, such as Accounts Receivable, inventory, real estate, etc. Overcollateralization refers to a situation when the value of the pledged collateral exceeds the loan value. Overcollateralization reduces credit risk for the lender by providing extra principal protection.
If things come to worst, a private debt manager should have a financial “cushion” to protect investors from taking a loss - and that’s where a credit reserve comes in place. Credit reserves are an allocation established by the lender to account for the probability that defaults may occur in the future and to provide an estimate of the losses, net of recovery from collateral liquidation, if needed.
Reputable credit managers should be open to talk about their credit reserve policies and explain the rationale behind it.
As a private debt investor, you should be comfortable with the concept of credit risk and be able to understand how investment managers manage it. It’s also crucial to estimate your credit manager’s ability to protect and recover capital if a credit event occurs, as well as to learn more about credit management processes used to protect investors’ capital.
*This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value.