Custodians seek specialists to value illiquid securities
Updated with correction
Custodians and third-party administrators increasingly are outsourcing valuation functions for private credit as the surge of institutional investor interest in the strategies raises concerns.
“All administrators have some capabilities in these assets, but only on very vanilla loans,” said Matthew Appel, managing director at private credit administrator Oak Branch Advisors, New York. “They can't service bespoke loans or asset-backed loans. Such loans are “very hard to model.”
Added Peter Sanchez, Chicago-based CEO of hedge fund services at Northern Trust Corp., “It's much more expensive to value private credit” because of the illiquid nature of the asset class, “making outsourcing of valuation more attractive.”
That outsourcing has benefited firms like Cortland Capital Markets Services LLC, Virtus Partners LLC and Oak Branch, which offer dedicated private debt administration. And while there's no industry tally of how much in private debt administration is outsourced, it's clear that with more institutional assets moving into private credit, there are more assets to be outsourced to specialized administrators.
An analysis by Pensions & Investments of hiring activity showed new assets committed to alternative credit strategies by institutional investors at $79.7 billion in the seven years and one quarter ended March 31. Commitments totaled $18.26 billion in 2016, up 348% from the $4.08 billion in 2010. Institutional commitments to distressed debt, special situations, mezzanine, structured credit and multiasset credit strategies hit a high of $18.3 billion in calendar year 2016, and the $7.4 billion in total committed assets in the quarter ended March 31 is the highest three-month total since the fourth quarter of 2009.
But along with more inflows into private credit come concerns about how those assets are valued. In Preqin's 2017 institutional investor survey on private credit, 62% expected to increase their investments in private debt in the long term, but 40% believed the difficulty in private credit valuations was a key issue facing the asset class in 2017.
It's that concern that has led some of the largest asset-servicing firms to outsource much of the valuation work, said Chad Burhance, New York-based CEO at Oak Branch, which was spun out May 22 from financial and risk management service provider NewOak Capital LLC, New York, in a management and employee buyout. Terms were not disclosed.
Before Oak Branch — previously known as NewOak Credit Services — began providing private credit administration services 18 months ago, “we got requests from third-party administrators to value illiquid loans,” Mr. Burhance said. “We found that a large swath of this was being done outside of traditional banking providers, and we got wind of that through private equity funds. When there are loan funds out there with 27,000 consumer loans and 5,000 residential mortgages, that's different from traditional private debt.”
At the time, NewOak surveyed custodians and large administrators “and found not one service provider had the capability to handle this,” Mr. Burhance said. “The rapid growth of the credit market caught administrators off guard.” Mr. Burhance said Oak Branch had seen a 100% increase in assets under administration in private credit in the past 12 months. He would not provide a figure.
Jeffrey Law, head of hedge fund services at fund administrator Virtus Partners, New York, said there are several challenges in private credit. “One of those challenges with private credit is that there's not a lot of trading activity, so valuations are model-based,” Mr. Law said. “To build the appropriate model, you have to pull all the financial data on that credit into that model and use a variety of market inputs to price that. That's a very labor-intensive process. You can't use a formula or algorithm to value that.”
The infrastructure necessary in private credit fund administration also makes it less cost-efficient to start up at larger asset-servicing firms, Mr. Law said. “Valuation to me is a small part of the story,” Mr. Law said. “From valuations, you need the infrastructure to do this, and it's different from private equity and hedge funds. In private credit, any kind of transfer is done manually. It's a little like real estate, like buying or selling a house. You need a dedicated staff to be able to do that. And it's tough to find the kind of people with this specialization. It makes it prohibitive for custodians and large fund administrators to do this.”
Virtus had $52 billion in assets under administration in fixed income and credit as of Dec. 31.
At BNY Mellon Alternative Investment Services, which outsources private credit valuations, the decision to outsource private credit or other asset class valuations depends on the asset class itself, said Chandresh Iyer, CEO. “It's a question of maturity and scale in that segment of the market,” Mr. Iyer said. “For us, it's more beneficial to leverage to third party in some cases.”
The surge in private credit parallels an earlier boom, Mr. Burhance said. “The growth in credit is eerily similar to the growth of over-the-counter derivatives trading in 2001-'02, coinciding with many (proprietary trading) desks spinning out to become hedge funds,” Mr. Burhance said. “That sent everyone scrambling to build out their trade confirmation capabilities and led to a successful business in hedge fund administration.”
Not the same
Northern Trust's Mr. Sanchez agreed with that parallel, but he said private credit fund administration will not run independently as fast as hedge fund administration did because of the cost and complexity of valuations. Oak Branch values assets for State Street Alternative Investment Services. Officials at State Street would not comment for this story.
Private credit fund administration “will become as critical as it's become on the hedge side,” Mr. Sanchez said, “but because it's so expensive, it will grow as the market becomes more institutionalized. It won't grow as fast as hedge funds, but over time you'll see more outsourced. The evolution will be slow, but it will happen.”
Larger custodians like Northern Trust, State Street Corp. (STT) and Bank of New York Mellon (BK) Corp. (BK) could build up their internal private credit fund administration capabilities, like they did with private equity, hedge funds and real estate, but Mr. Sanchez that's more likely to happen as it has with the other asset classes — through acquisition.
“We wouldn't build internally, just like what we saw on the hedge side,” Mr. Sanchez said. “We could acquire the capability or, more likely, there will be more vendors that will increase the competition for the business.”
This article originally appeared in the May 29, 2017 print issue as, "Complex private credit boosts outsourcing".