Wealth managers assess the risk of default for private debt investments by considering several factors. Here are some of the key factors:
- Manager selection: Wealth managers evaluate the manager’s track record of success in managing private debt investments. A competent manager becomes critical once a decision is reached to employ alternative credit strategies 1 . The manager’s experience and expertise in managing private debt investments can help to mitigate the risk of default.
- Interest coverage ratio: Wealth managers evaluate the borrower’s ability to service the debt, calculated via the interest coverage ratio. A borrower’s ability to continually service that debt is the primary indicator of default risk 2 . For borrowers with interest coverage of at least 3x, the long-term default rate is around 2%.
- Restructuring or workout situation: Wealth managers evaluate the potential for a restructuring or workout situation. If an investment is starting to falter, private credit investors have the advantage of being able to rely on fundamentals for early warning signs and be proactive to potentially prevent default, with lending contracts often including provisions for required reporting 2 .
- Diversification: Wealth managers evaluate the diversification of private debt investments to minimize risk. Private debt funds of funds invest in a variety of third-party debt funds depending on the fund strategy, providing greater portfolio diversification 1 .
- Complexity: Wealth managers evaluate the complexity of private debt investments. Some private debt strategies focus on assets or structures too complex for typical traditional lenders to underwrite, relying on complex approaches to properly evaluate and manage risks that they can understand and evaluate properly. 3 . Wealth managers should choose private debt investments
- Lack of information: Wealth managers should be aware that private debt remains a very relationship-driven investment. With a smaller pool of lenders available, fewer people are aware of the investment opportunities, which can lead to a lack of information 4 .
Overall, wealth managers assess the risk of default for private debt investments by evaluating the manager’s track record, interest coverage ratio, potential for restructuring or workout situations, diversification, complexity, and lack of information. By evaluating these factors, wealth managers can make informed decisions about private debt investments that align with their investment objectives and risk tolerance.