Expect the unexpected: the importance of active asset management in private credit

What is an acceptable loss? The answer you’ll receive will differ between investment managers, private equity houses and various other money managers who are, by and large, either focused on zero loss (largely investment-grade (IG) credit investors) or some ‘acceptable’ level of loss (the value-added space) subject to the achievement of a target internal rate of return (IRR).

Over the past three years, markets have had a series of unprecedented '1-in-200 year' events and are currently working through the challenges posed by a recessionary environment; it seems active asset management comes to the forefront, again. 

It's comparatively easy to lend money, relative to trying to get it back when things don’t go according to plan. The latter can take the guise of poorly underwritten business plans, failure of assets to perform as expected and corporate misrepresentation / fraud to highlight a few of the more obvious, or, as we have seen during the pandemic, the completely unexpected. 

While borrower selection, prudent underwriting and appropriate structural protections are a good starting place for prudent/protected investment, once the transaction is funded, investors rely on asset managers’ monitoring and control, attention to detail, and urgency to ensure we are on top of asset performance … so that if (read ‘when’) the unforeseen occurs we are quickly able to react.

The monitoring of financial information and related covenant reporting is one key area to this, as well as regular portfolio reviews and investment / credit committee updates. The days of making an investment, ‘putting it in the draw’ and moving onto the next one, is not part of the asset manager’s mindset. Our obligations and fiduciary duties are to our investors/clients, to demonstrate we know what is going on with our transactions. 

New technology is now assisting this specific process. Bespoke, fully auditable software – either built in-house or via working with strategic partners – allows us to now enjoy data outputs that are all-encompassing with meaningful information at a click of the button/ or the opening of an app.

However, we believe where active asset management really comes into its own is when there are challenges, which may turn into potential future issues, which then turn into actual problems.

At LGIM our investors want comfort that the business has a function with the requisite skill set, gravitas and network of professional advisors to call on. This proffers the ability to develop, manage and execute a carefully considered remediation strategy; ideally, preventing the escalation of the matter and working with our borrowers to find a consensual solution, if possible, but always primarily to protect client interests. This ability to engage early is where our approach in private markets may also differ from public markets.

These instances tend to be relatively limited in frequency (albeit occurring somewhat more frequently in the market over the past three years for obvious reasons). However, they can happen at any point and take up a significant amount of time and resource. As such, having a dynamic and appropriately skilled team who are on top of and able to manage these situations, is essential.

Examples of this work are varied. At the more challenging end a recent example involved replacing counterparties in a structured debt product following an insolvency event and the creation of new lending vehicles to maintain the fixed income nature of the investment. We have undertaken various loan and asset sales to facilitate exposure reduction / to rebase debt levels, as well as working with borrowers to provide short-term transaction extensions to bridge liquidity windows or to facilitate the execution of business plans and arrange orderly exits.

In more of a BAU context we also work with our borrowers who have more of an active treasury management strategy to amend, restructure and rebase transactions to help facilitate optimal capital structures while still ensuring the expected cashflows are received or alternative remuneration is received over a transaction’s life, thereby creating potential opportunities and value for our clients.

Overall, where we believe active asset management really works well at LGIM, is having a specific business function within Private Credit with a ’bottom-up’ asset level focus, which manages the relationships with the borrowers we face and clients we represent. In this regard, from inception of a transaction, members from the relevant business area(s) stay working with the transaction, providing continuity during the life, and demonstrating ownership to those we represent. 

As we travel, hopefully, towards some relative market stability during the second half of 2023, we believe there are some interesting investment opportunities. That said, it’s important not to get carried away. While we might love the ‘credit, sponsor, asset, and returns’, if it all goes wrong … how do we get our money back?