Fund administration: Cortland on first-time credit funds

greg myers 180
Greg Myers

stuart wood 180
Stuart Wood

When private equity firms launch their first credit vehicle, they tend to under-invest in infrastructure for that new business, or expect an outsourced provider to do it all. 

The reality is that credit funds face unique administrative, marketing and reporting challenges that require specific in-house expertise. And limited partners have grown sophisticated enough to inquire into the administrative aspects of that lending platform. 

We sat down with Greg Myers and Stuart Wood of Cortland Capital Market Services, a leading provider of third party and outsourced middle office services to credit lenders and investment managers, to discuss what general partners need for their first credit vehicle. Having partnered with plenty of GPs launching their debut credit platforms, they’ve seen the good, the best and the ugly.

In your experience, what are some of the structural challenges GPs face when they launch their first credit vehicle?
A traditional bank comes with plenty of in-house infrastructure. They have financial accounting systems, internal audits and compliance personnel that help maintain everything that needs to be in place for a lending institution.
Private equity firms tend to be incredibly lean. There are a few deal originators, some back-office folks and a couple of others in legal and compliance. Then when GPs decide to move into a new discipline like credit, they don’t have the infrastructure that a bank takes for granted. 

It may require an investment in new systems and hiring new support staff. If they’re registered with the SEC, they’ll have to develop processes for submitting what they need to share with regulators. And just because they can address SEC inquiries into their private equity activity, that doesn’t mean they’re equipped to meet regulatory standards as a credit platform.

But a lot of today’s GPs do have relatively robust back offices, even some of the middle market players that Cortland services frequently. Do they always need to hire more administrative staff for their credit vehicles?  
That’s fair. We do see a lot of private equity funds getting into this space that have large back offices that do their accounting and their reporting and compliance internally but there are nuances to the credit space. There’s more activity to handle administratively with these platforms such as the tracking of various loans, the trade settlement process, the syndicating, being the agent and so forth that are skill sets a traditional back office probably doesn’t possess.

What are the reporting challenges that come with these platforms?
Investors want more transparency into what’s going on in the underlying portfolio so the back office needs to determine what data points are relevant to investors in the fund and how to extract them from a system. It can be a combination of financial information such as realised and unrealised gains or interest income, but this may involve details related to items more along the lines of the security master data such as ratings or spreads. GPs can create their own reporting, but there’s value in having someone with experience in these matters. This is where an outsourced solution demonstrates their bona fides.

What marketing challenges should GPs expect when they diversify into credit?
Investors in these platforms are looking for something different. It’s a capital preservation and income play. A lot of these credit funds are structured in such a way that they won’t get multiples on the return. A bank loan pays back its principal and its interest. It’s not like a private equity-backed company where one might sell it for five or six times the price. 

We’ve seen a few funds struggle to raise money because they haven’t started the process by speaking with their existing LPs to discuss what structure or design they’re looking for from their credit plays. Instead, they draw up the Limited Partnerships Agreements and other legal documents only to find there isn’t an appetite for what they are offering.

An offering that comes from essentially a first-time player in the space?
Yes, we can’t forget this move involves venturing into a new asset class, where the firm doesn’t have a track record. If they’ve traditionally been a private equity fund and that’s how they’re seen in the marketplace, having those same LPs trust them as a credit fund can be a challenge.

In the case of a large institutional investor, they’ll want to understand the private equity firm’s front-office talent and infrastructure. That GP will face the same level of operational due diligence as their buyout fund and perhaps a bit more, since the firm hasn’t proven themselves as a credit platform yet.

And there’s only so many ways to work as a lender, so how does the GP market the fund without a track record?
What a manager can do to differentiate themselves is to explain their deal access pipeline or unique industry focus. They can highlight the experience of their deal underwriters and perhaps their affiliations with other private equity firms with whom they’ve done deals in the past. From our perspective, the investor wants to know that the manager has access to dealflow relevant to their strategy, and the right organisational structure and back-office skills to accurately execute.

So, what kind of staff should they bring in-house? As a service provider, do you argue they can outsource everything they need?

We are very wary of folks that have the mindset that ‘We’re outsourcing everything to you, so you handle it’. At a minimum, we want to see someone at the controller level that has pretty solid experience with credit funds from an accounting perspective. 

As we said before, LPs are going to do plenty of operational due diligence and want to know who in-house will be addressing any knowledge gaps. They want to see someone with the right level of experience to review and approve the work done by the in-house staff or the service provider.

How should they find the right controller for that new credit fund?
Ideally, they’d tap someone with experience at a similar platform, and not simply from the public accounting world. The skill set to do audit and client work could be significantly different from the asset management work and accounting required. For a start-up strategy, they’d be better off tapping someone with private equity or private credit experience so they fit with the culture, especially if it is an internal credit platform.

The world of private credit is just like the world of private equity; a small group of very interconnected people. Since they all know each other, vetting can often be done quite well through the personal networks of the deal originators in the new credit fund.

Do they need to hire anyone else to round out the team?
That depends on the specifics of the situation. They’ll need someone to negotiate with banks for leverage, and the current CFO is certainly equipped for that. However, as much as we might be able to handle communications, there should be a dedicated IR person to help discuss strategy and how the investments are performing with investors. And depending on their SEC registration status, they should have a person who owns compliance matters for this new fund.

What’s the argument to not simply building the rest of the team in-house?
Service providers offer two things efficiently: technology and the reporting. They won’t have to acquire expensive systems to run and administer the fund and they’ll be able to leverage best-in-class reporting that already exists instead of developing that internally by gauging the preferences of targeted investors. Additionally, several institutional LPs will not invest without participation from an outsourced fund administration solution.

How do they ensure that a service provider is worth the price tag?
Any potential fund administrator needs to have experience in credit. Some providers claim that a fund is a fund is a fund and say they can handle everything. And some accounting systems out there just can’t manage bank loans, which means the work needed to handle them can create real operational risks. 

In terms of accounting skills, the providers need specific experience with loans. The clients that do the right level of diligence want to meet the day-to-day team who are responsible for making the journal entries and posting the transactions. Those folks should be CPAs or CPA equivalents with experience working on bank loans. This works best as a partnership, where our staff are treated as an extension of your own.

 This story is sponsored by Cortland Capital Market Services and appeared in the Fund Administration Special 2017 published in Private Equity International in June 2017.