Transitioning from equity to credit in private markets

16 November 2023
Transitioning from equity to credit financing in the dynamic private markets landscape is a major strategic decision that requires careful consideration.

Companies often make this transition to broaden their financing sources, optimise their financial strategies, and gain stability, flexibility and long-term sustainability. Although the rewards can be significant for managers keen to broaden their investment scope, it is crucial to assess the potential challenges and risks before making the switch.

We interviewed two private equity professionals to better understand the obstacles that arise when businesses expand from equity to credit in private markets and to identify best practices that can lead to a successful shift.

Hoan Nguyen is Vistra’s director of private equity and real estate. Based in Singapore, Hoan has over 17 years of experience as an industry specialist advising managers, investors, and other participants in the asset and wealth management space. 

Tamara Sablic is Vistra’s director of business development in New York. She works with clients to provide comprehensive corporate, fiduciary and administrative services across markets.

What are some motivations for transitioning from equity to credit in private markets?  

Hoan: The most obvious answer is interest rates and yield in the near term. The increase in interest rates is adversely affecting equity valuations for many, making credit returns more attractive.

At the same time, portfolio companies and their founders are naturally hesitant to raise equity financing rounds when valuations are depressed. From a long-term perspective, traditional lenders — faced with increasing regulatory costs and constraints — are rationalising their loan portfolios.

These near- and long-term trends have created an opportunity for managers with strong domain experience in specific sectors or industries to use their expertise to identify projects and companies with compelling returns and suggest credit financing in the current high-interest environment.

While some managers may prefer a focused, asset-specialist approach, others are looking to offer their investors different asset classes with varying profiles in this high-interest environment. Offering existing clients broader investment opportunities may help attract more investment from existing investors, enabling managers to leverage existing relationships and potentially easing costs of customer acquisition. 

Tamara: If you are a manager who runs an equity-based strategy, consider adding a credit strategy to your portfolio. This would help fulfil the needs of borrowers who can’t secure funding from traditional sources, like banks. Such borrowers can work with credit managers to obtain funding.

What challenges arise when shifting from equity to credit in private markets?

Hoan: Managers looking to expand into private credit will likely face challenges across their entire business functions, including the front-, middle- and back-office functions.

From a front-office perspective, we observe our clients struggling with the perennial challenge of talent acquisition. Identifying and acquiring talent is always difficult and costly, especially in Asia and even more so in emerging markets. Therefore, hiring skilled individuals for a new asset class in investor relations and portfolio management will be a costly upfront investment, not to mention the expenses of retaining such talent. 

The skills required for middle-office roles in credit and equity are quite different. For boutique managers in the PE and VC space, middle-office functions that support equity-focused investments are typically light. Accordingly, managers may find making the transition to a credit strategy will require investment in a more substantial middle office. Monitoring of credit risk, performance metrics, collateral and settlements are just a few examples of basic middle-office tasks.

Managers should also be prepared for potentially higher legal costs on a per-deal basis. This is particularly relevant for managers investing across multiple jurisdictions, where emerging markets in Asia can be especially challenging. Protecting the rights of foreign investors is crucial.

Lastly, credit investments and their derived incomes are taxed differently, both onshore and offshore, when compared to equity investments. Where investments are made across a number of different jurisdictions, managers should actively seek tax advice to ensure that structures are tax efficient and incorporate relevant tax treaties and potential tax uncertainties (particularly for emerging markets).

Planning ahead should include the appointment of the right fund administrator to support a manager's multi-asset portfolio. The right administrator should have the expertise and specialised tools at the fund and loan administration levels. If your administrator lacks the required experience and software, you will place an additional burden on your already overworked middle- and front-office staff.

Tamara: I agree with Hoan’s comments. Adding or switching to a credit strategy from an existing equity strategy is not a simple task. It requires expertise at every step of the process. Does your investment team have the relevant experience and track record? Is your middle- and back-office team knowledgeable in credit and understand its details? Are you working with a competent third-party loan and fund administrator? All these factors should be considered before entering the private credit fund market.

You mentioned the need for expertise at the fund and loan administration levels. What are the key differences between loan administration and fund administration?

Hoan: Fund administration and loan administration differ in their focus. Fund administration deals with the reporting requirements at the fund level. Conversely, loan administration is primarily concerned with the administration of the underlying loans, such as agency, recording, analysis and other related tasks. The data gathered from loan administration is then used to support the fund's reporting requirements. It is important to note these basic differences, as competency in one area does not guarantee competency in the other.

Why are many private equity managers unequipped to handle loan administration and fund administration services?

Hoan: Many fund managers in the private equity and venture capital space are interested in entering the credit market. While this may be their first foray in credit-specific investments, managers are keen to leverage their existing domain expertise in a specific investment space whilst offering their investors a new asset class.

However, to effectively administer loans, managers should be prepared for a separate set of skills, processes and systems required to capture relevant data points and report key risks. Therefore, it is important for managers to understand that their existing systems and processes designed for equity investments may not be appropriate for credit investments and the underlying loan administration level.

Tamara: In his analysis, Hoan accurately distinguishes between loan and fund administration. If a manager is considering starting a loan-based investment strategy, they must consider how to handle asset-level calculations and reporting efficiently, as well as fund-level reporting. 

Managers used to rely on Excel to manage their loan administration, which was effective for a smaller, less complex set of loans. However, as managers face larger and more geographically diverse loan portfolios, it has become challenging to manage and report on Excel, which is manual and prone to errors.

The loan administration market has progressed, and managers now have options for back-office providers with purpose-built systems and specialized knowledge to support them at both the asset level and the fund level. Engaging a loan administrator to oversee the underlying investments made by the fund structure allows fund managers to concentrate on other crucial aspects such as bringing in new investors into the structure, originating new investments or setting up new structures. 

Why do loan portfolios require the ability to capture different data points? And why, if a manager doesn’t have access to the right team and software, is it very difficult to capture different data points with Excel spreadsheets?

Hoan: Even if a manager extends a loan to an existing portfolio company, the loan will naturally have a different set of risks and rewards that accrue to investors. This means they need to be managed and recorded differently and require practitioners to capture specific data points. Under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP), loans are accounted for differently, resulting in different financial risk disclosures. Therefore, the loan administration system needs to gather data points, such as interest type (fixed or floating), varying fees, collateral, amortised cost schedules, and many more, given the complexity of credit instruments in the credit space.

Manual and unstructured methods such as spreadsheets are not suitable for recording these data points, as they can be complex and voluminous. Although the manual approach may be used for a few loans, it becomes impractical when dealing with numerous and complex loans. Downstream to data capture, manual methods have several drawbacks, such as limited data analytics and customised reporting.

It may become very tedious and time-consuming to customise and scale reporting to investors, stakeholders or internal risk management when manual methods are used. Additionally, the development of stress testing tools becomes challenging to develop with unstructured data sets.

Tamara: Following Hoan’s comments, it’s important to note that credit investments are essentially agreements between the lender and borrower. Unlike exchange-traded equity, private credit investments are not standardised. Consequently, each loan investment is unique and requires tracking and calculating different data points.

Depending on the volume of loans involved, it can become problematic to process such information using Excel. Due to this, managers who launch new credit funds usually prefer to engage expert third-party loan and fund administrators instead of building the infrastructure internally or purchasing it.

What best practices can result in a successful transition from equity to credit?

Hoan: From my front-row seat, I have observed the challenges and successes of managers entering this space. Credit managers with experienced teams tend to not underestimate the differences between their existing processes around equity investments and those of credit, and prepare for the necessary investments in the front, middle and back office. We’ve observed that start-up and boutique managers successfully bridge these differences by leveraging their outsourced service providers. This enables to them to invest more time, energy and talent in their core front-office capabilities.

Successful managers will fully understand the challenges, build out their middle offices where they cannot reasonably outsource, invest in relationships with legal counsel, and engage an administrator with the right people, processes and technology to not only administer the loans but also provide seamless integration from loan to fund administration.

Tamara: I completely agree with Hoan. I would also mention that launching a successful new strategy requires careful analysis and planning. Two key components that should not be overlooked are building the right expert team, which includes investment, middle-office and back-office professionals.

Additionally, it is essential to engage expert partners, such as legal counsel, tax structuring professionals, loan agencies, loan and fund administrators, and independent auditors. By investing time and effort into this process, managers can ensure they are on a path to success.

Can you provide examples of a successful transition from equity to credit?

Hoan: We have encountered a boutique venture capital manager who has made great strides in credit investments. This manager has an established track record in the venture capital space, but historically, only invested via equity instruments. Their transition to credit was thrust upon them due to the high-interest rate environment driving both a pull from investor demand and a push from founders who will seek alternative financing, considering depressed valuations.

Whether their investments will be successful, it is a bit early to tell. However, we observed that the transition process for this manager was organized, focused and efficient as they engaged the right service provider. Key to their success was leadership that was hyper-focused on the opportunity cost of talent rather than trying to do everything themselves. They rightfully focused their scarce time, energy and talent on their core activities and outsourced the immediate and long-term burden of people, processes and technology of their middle and back office to the right service provider. 

Tamara: Many of our global private equity managers have a multi-strategy approach. They may run an equity or a real estate strategy and now are exploring a credit strategy. We’ve seen managers add credit strategists organically or through acquisitions. The time to market tends to be faster via acquisition versus organic growth, but both are viable ways to launch a credit strategy.