As direct lending matures and defaults begin to rise, institutional investors are placing greater emphasis on underwriting discipline, workout capabilities and manager specialisation.
Manager selection is becoming increasingly important in direct lending, according to a range of industry experts speaking at Private Markets Profile’s Private Credit Forum.
The asset class has remained resilient while navigating a series of market shocks in recent years, from the Covid-19 pandemic and rising interest rates to geopolitical uncertainty and rapid technological change.
Adam Grimsley, private and alternative markets consultant at Apex Group, noted that private credit had largely delivered on investor expectations despite this challenging backdrop. “We’ve had Covid-19, we’ve had wars and we’ve had a rate cycle that moved from zero to 5.2%,” he said. “But private credit has done pretty well.”
However, he warned that assessing future performance is becoming more complex. Investors face growing uncertainty around areas such as artificial intelligence, changing valuation assumptions and rising default rates.
“We [are being asked to] underwrite one of the preferred sectors for private equity, technology and software,” Grimsley said. “That’s a pretty difficult task at the moment.”
He argued that the key differentiator will increasingly be manager quality rather than the asset class itself. “The asset class will perform pretty well, but picking the best managers, analysing those managers and holding their feet to the fire is going to become far more important,” he said.
[L-R Aida Feriz, Adam Grimsley, Walter Seitz and (chair) Ian Milton]
Grimsley said investors are paying close attention to whether managers remain consistent with the strategies and sectors they originally set out to pursue, particularly as competition for deals increases and firms seek to deploy larger pools of capital. “We really look for managers that are able to show discipline,” he said.
That includes examining whether managers have expanded into new sectors simply to grow assets under management or whether they possess genuine expertise in those areas. “It’s important not to be tourists in different sectors,” Grimsley said.
Walter Seitz, senior investment officer at the International Finance Corporation, concurred and added that specialisation remains one of the key characteristics he looks for when assessing managers in emerging European private debt markets. “What we don’t like is tourism,” he said. “Diversification is nice, but opportunism is not. Specialism is more credible.”
He also emphasised the importance of underwriting process quality as well as reporting, transparency, and valuation.
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The discussion also highlighted the growing importance of workout capabilities as portfolios encounter stress.
While direct lending default rates have risen, Grimsley noted that many situations are being managed through payment-in-kind (PIK) structures, covenant amendments and maturity extensions rather than resulting in permanent capital losses.
That makes it increasingly important for investors to understand how managers behave when loans come under pressure. “What are their skills? What are their capabilities?” Grimsley asked. “What discipline do they have?”
Seitz agreed that workout expertise is one of the most important elements of manager assessment, particularly in sponsorless lending strategies. “Workouts are extremely important,” he said. “At the end of the day, you have to have a way to get out.”
Investors are also broadening their due diligence beyond origination and underwriting. Grimsley said valuation practices have come under much greater scrutiny, particularly as questions emerge around private market pricing and portfolio transparency. “There’s been a huge amount [of discussion] around valuation concerns,” he said.
Seitz identified reporting, transparency and valuation as three of the most important factors his team evaluates when assessing managers. He also argued that credit ratings can play a valuable role in improving consistency and transparency across portfolios. “Valuation is a key concern for us,” he added.
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Not all allocators are equally convinced. Aida Feriz, executive director at Wimmer Family Office, said her organisation continues to favour private equity over private credit and remains cautious on SME direct lending.
“For direct lending, we find SMEs quite risky because your only collateral is a cash flow,” she said, contrasting the strategy with real estate debt where investors benefit from tangible collateral.
The panel concluded that direct lending investors are becoming more demanding in how they evaluate managers, becoming increasingly focused on underwriting processes, workout capabilities, valuation methodologies and sector expertise.