The private credit market has exploded over the past decade. Macroeconomic factors and a shifting regulatory landscape have driven a surge in private assets under management. At the same time, private credit funds expanded their offerings, adding increasingly customized lending solutions to their portfolios.

Bespoke loan terms allow lenders to personalize agreements, terms, and repayment structures to cater to borrowers' needs. While growing demand for these lending arrangements has presented private funds with new opportunities, it has also introduced new challenges.

Private credit market transformation

Several factors are driving the rise of bespoke loan terms, its associated challenges, and the importance of technology's role in managing these increasingly complex products. Preqin’s 2024 global report predicts that private credit AUM will hit $2.8 trillion by 2028, almost double the size of the $1.5 trillion in 2022.¹

Multiple aspects, including a long period of near-zero interest rates can be credited with driving this growth in private assets. Zero interest-rate policy (ZIRP), which characterized much of the central banking policy worldwide following the 2008 Global Financial Crisis, incentivized investors to seek higher yields in alternative assets like private credit.

Regulatory changes have also contributed to the market’s transformation, spurred on by a public market fallout post-2008. Regulatory bodies implemented more stringent underwriting standards for traditional financial institutions. Consequently, these institutions faced increased constraints in certain credit activities, like extending loans to borrowers with below-prime credit profiles or serving borrowers with financing requests falling outside conventional lending parameters. This environment created a lending gap that private credit providers eagerly filled.

More recently, with interest rates reaching historical highs worldwide and inflation persisting above central bank targets, private credit offers investors higher yields, added diversification, and more inflation-hedging opportunities. Where traditional banks once dominated the landscape with standardized structures, like mezzanine corporate loans, private credit managers have stepped in with loan agreements increasingly tailored to individual borrower needs and demands.

Private credit growth leads to loan customization

In 2011, there were only a hundred private debt funds globally. By Q3 of last year 2023, that number jumped an order of magnitude, reaching roughly 1,080 worldwide.²

With more money and more players comes fiercer competition. In response, private credit managers have been diversifying their products, increasingly offering unique loan agreements.

More sophisticated and customized lending has created new challenges for private credit managers, particularly in tracking loan performance, ensuring compliance with loan covenants, and maintaining accurate and up-to-date records.

What makes a loan bespoke?

Bespoke loans are simply loans customized for a particular borrower. Unlike an off-the-shelf, traditional agreement, these loans often include unique terms, conditions, and repayment structures.

Borrower-centric agreements can have a specific interest rate structure that shifts annually based on predefined criteria, such as changes in the borrower’s earnings or other economically significant metrics. Bespoke loans can also include flexible and customized repayment schedules, like delayed draw provisions where the borrower can access funds at irregular intervals, or milestone-based repayments tied to specific business achievements. The loans can also be secured by various assets, like intellectual property, that may not be as common with traditional loans.

Borrowers can request specific repayment arrangements, like payment-in-kind (PIK) loans. With a PIK, a pre-determined portion of interest is tacked on to the principal amount, rather than paid out in cash, allowing the borrower to conserve cash flow during the loan term.

Customized lending structures like these allow borrowers to ensure their financing aligns with their objectives. But for the lender, these loans introduce complexity into the loan management process, especially as their loan portfolios grow.

Implications for private credit managers

As bespoke loans become more prevalent, private credit managers face considerable operational and technological hurdles. Managing a portfolio of bespoke loans demands a level of flexibility and precision difficult to achieve with traditional loan management systems, which may comprise a collection of Excel workbooks.

One of the larger challenges is the need to reconcile different books of record — the Investment Book of Record (IBOR) and the Accounting Book of Record (ABOR). This task can lead to discrepancies and inefficiencies.

Private credit managers must constantly reconcile IBOR and ABOR to ensure loan activity is accurately recorded and reported. Timing differences, data mismatches, different nomenclatures and units of measurement, or entry errors all create discrepancies between the two books. As a result, interest payments, principal repayments, fee collections and other activities, need to be scrutinized for accuracy. This process is time-consuming and error-prone, particularly as the volume and complexity of loans increases.

In addition, the risk of mismanaging the loans grows as assets grow. Sending incorrect terms to borrowers or other documentation errors can bear serious consequences, from financial losses to legal challenges, to reputational damage.

The evolving relationship between banks and private credit

The evolving private lending space has created a complex relationship between banks and private credit firms—one that can be described as both collaborative and competitive. Banks are no longer the primary source of financing for businesses. In 2022, banks were responsible for 44% of corporate lending in the United States. Just one year later, that figure dropped to 35% as private credit firms stepped in.³

With the ability to offer flexible and tailored lending solutions, private credit firms can help fill the gap that traditional banks have struggled to serve. By co-lending with private credit players or offloading portions of loans, banks can benefit from maintaining client relationships while reducing their exposure to riskier investments. At the same time, private credit funds can benefit from higher yield opportunities.

Technology’s role in supporting private credit portfolios

Given the challenges associated with managing bespoke loans, private fund managers can benefit from leveraging advanced technology solutions designed to accommodate the unique features and complexities of these agreements. Some features that support their needs include:

Single Source of Truth: Software that can provide managers with a single line-item location for both IBOR and ABOR. This allows the manager to quickly view accurate and up to date data.
Customized Loan Tracking: The ability to track specific terms and conditions of each loan, including interest rate adjustments, repayment schedules, and PIK arrangements. This level of customization ensures that all loan activity is accurately recorded and reported.
Principal Activity Management: The functionality to process and update relevant position and contract information in real time, ensuring that all principal activity, such as drawdowns and rollovers, is accurately reflected in the system.
Enhanced Reporting: Detailed insights into loan performance, including interest accruals, payment history, and compliance with loan covenants.
Improved Client Communication: A centralized data management system to enhance client communication by providing private credit investors with accurate and current information on loan performance, improving trust and confidence.

Impact of limited technology

Despite the growing complexity of private credit market offerings, many firms still rely on antiquated systems to manage loan portfolios. While these tools may be sufficient for managing a small number of standardized loans, they fall short when dealing with a large and diverse portfolio of customized agreements.

Relying on manual processes and legacy technology introduces operational risks like data entry errors, inconsistent record-keeping, and a lack of visibility into loan performance. These risks only compound as the loan portfolio grows.

As private credit firms add a second, third, or fourth fund, more sophisticated solutions become critical. After all, in 2023, PitchBook estimates the average direct lending deal size stood at roughly $170 million.⁴ Without the proper software backbone, private credit firms risk management leading to financial losses, reputational damage, and visits from regulators.

What’s next for bespoke lending?

As private lending continues to evolve, increasingly customized products will likely proliferate. Borrower appetites for customized loan terms and investors' appetites for higher risk-adjusted returns provides an opportunity for private credit firms to offer further customize bespoke loans and gain a competitive advantage. By investing in advanced technology platforms, firms can meet the evolving demands of borrowers and clients and thrive in an increasingly complex and competitive market while setting themselves up to scale.

Sources:

1. Private debt’s rapid growth merits closer scrutiny, IMF says, Prequin, April 2024

2. The Inexorable Rise of Private Credit, BNY Mellon, June 2024

3. How can banks adapt to the growth of private credit? Deloitte, August 2024

4. Private Credit Markets Are Growing in Size and Opportunity, Cambridge Associates, April 2024