The Meteoric Rise of Private Credit Funds

Here in the Cayman Islands at KPMG LLP, we have had an extensive portfolio of Private Credit Fund (PCF) audit and tax compliance clients since the early 2000s, the number of PCF audit and tax proposals received over the last eighteen months has been unprecedented. In this piece, we'll look into what our clients are telling us are the best opportunities on the horizon, and consider how to navigate the risks that PCF managers face.

Despite interest rates starting to fall and the general belief this trend will continue through 2025, we are not seeing a decrease in the number of PCF launches.

As the private credit market continues to evolve, new opportunities are emerging that promise to increase growth and diversification. From the expansion into broader asset classes to the rise of innovative financing structures and the influx of retail investors, the PCF landscape is poised to undergo transformative changes in the years ahead. In our discussions with clients, these are some of the opportunities they see:

Broadening Asset Class Exposure

Traditionally, PCFs have focused on mid-sized companies and businesses with lower credit ratings. However, the success and maturation of the asset class have led to its expansion into a broader range of asset classes and borrower types. Asset-backed finance, including aircraft loans, equipment leasing, real estate, and infrastructure financing, presents growth potential. These asset classes offer attractive risk-adjusted returns and align well with institutional investors' long-term investment life cycle.

Innovative Financing Structures

The private credit market has proved to be nimble, resulting in the emergence of innovative financing structures that cater to the evolving needs of borrowers and investors alike. Examples are net asset value (NAV) lending and credit risk transfer (CRT) deals.

Retail Investor Participation

Historically, PCFs primarily served institutional investors and high-net-worth individuals. However, regulatory changes and new investment vehicles have allowed retail investors to participate in the private credit market. In the U.S., business development companies and ETFs are popular options for retail investors seeking exposure to private credit investments. In Europe, the introduction of European Long-Term Investment Funds (ELTIFs) has made private market investments, including private credit, accessible to retail investors. These regulatory developments have democratized access to PCFs, expanding the investor base and increasing market liquidity.

Tech and Data Analysis

Integrating new tech and data analysis will enhance PCF's operating efficiency and improve risk management capabilities. Machine learning algorithms and advanced data modeling techniques can aid robust credit underwriting processes, enabling informed decisions based on comprehensive risk assessments. Adopting digital lending platforms and online marketplaces can streamline origination and distribution processes, promoting transparency and liquidity in the private credit market.

Sustainability and Responsible Investing

As investors focus more on ESG factors, PCFs must match their plans with sustainable and responsible investing. They should include ESG elements in credit checks, portfolio building, and risk control to draw money from investors who care about ESG. 

While the private credit landscape presents compelling opportunities, navigating the associated risks and challenges is critical. From operational complexity to heightened scrutiny from regulators and the ever-present threat of economic downturns, PCF managers must remain alert and proactive in mitigating these risks.

Regulatory Scrutiny and Transparency Concerns

As the private credit market expands and broadens its investor base, regulators have started to examine PCFs more closely. Concerns surrounding transparency, risk management practices and potential systemic implications have prompted calls for enhanced oversight and reporting requirements.

Regulators such as the U.S. Financial Stability Oversight Council and the European Securities and Markets Authority (ESMA) have voiced concerns over the lack of transparency, covenants and underlying asset quality. Addressing these concerns through improved disclosure practices and the use of industry best practices will be key to ensuring the long-term sustainability of the private credit market.

Economic Cyclicality and Default Risk

While PCFs have demonstrated resilience during periods of economic stress, they are not immune to the risks associated with economic downturns and credit cycles. In recessionary environments, borrowers may face financial difficulties, leading to an increased likelihood of defaults and potential losses for PCF investors.

Effective credit underwriting, robust portfolio monitoring, and proactive risk management strategies are essential for mitigating default risks. PCF managers must exercise due diligence in assessing borrowers' creditworthiness, monitoring financial covenants, and implementing early intervention measures when signs of distress emerge.

Operational complexity

The operational complexity of running a PCF is often much more significant than that of a private equity or hedge fund, which stems from various factors. Firstly, private credit funds are often bespoke and sophisticated, implying that contract terms, including cash flow, timing, and fee structures, can be negotiated on a case-by-case basis. This tailored approach results in non-standard fee structures and requires effective systems to accurately manage, account for, and report these complex arrangements.

Secondly, the structure of private credit funds contributes to their complexity. Unlike private equity or real estate funds, which may only involve a handful of entities, a private credit fund might incorporate dozens of entities within its structure.

Lastly, the sheer volume of loans these funds make adds complexity. Some PCFs may make thousands of loans with unique terms, conditions, and covenants. Keeping track of all this information can be challenging.

Financial reporting

The factors contributing to operational complexity in PCFs also result in more challenging financial reporting. Ensuring the accounting function, whether internal or external, has the requisite capacity, experience, and systems to complete financial reporting accurately is vital to meeting the ever-increasing demands of investors and regulators.

Precise yet efficient valuation services for the portfolio are paramount. The ever-increasing diversity of investors, fund vehicles, and portfolio investments has driven credit fund managers to reassess and enhance their valuation operations and reporting capabilities. Striking the perfect balance between internal, external, and technical valuation resources is a critical decision that managers are tackling. KPMG provides alternative investment valuation services, including mark-to-market valuations, assistance with fair value issues, and private debt valuations.

The number of public reprimands and penalties issued by the SEC and other regulators against PCF advisers for incorrect financial reporting has increased significantly. The SEC’s director of enforcement, Gurbir Grewa, recently stated “I’m concerned about valuation issues: how they’re marking these investments because they are illiquid. I’m concerned about fee and expense issues, and with conflict-of-interest issues¹.”

Given this focus the importance of engaging an auditor with experience auditing private credit funds cannot be overstated. These are not typically "vanilla" audits, and early engagement by an auditor who understands the nuances of PCFs ensures that financial reporting and valuation documentation align with year-end reporting requirements. This proactive approach prevents surprises, especially those that may arise at the last minute. It's all about ensuring financial transparency, accuracy, and compliance. KPMG LLP’s dedicated private capital teams have a proven history of auditing complex PCFs. They stand ready to help you tackle possible problems early to ensure a smooth audit process.

The private credit landscape has transformed from a niche market to a significant cog in the global financial system. The expanding and diversifying market offers opportunities for broadening asset class exposure, innovative financing structures, and increased retail investor participation. However, these opportunities come with risks such as operational complexity, regulatory scrutiny and economic downturns. To succeed, industry participants must embrace innovation, leverage technology and engage the right service providers. By addressing challenges and capitalizing on growth opportunities, PCFs can continue their growth through 2025.

KPMG LLP remains committed to providing industry-leading audit, tax and advisory services to PCF managers. With a deep understanding of the regulatory landscape, risk management practices and operational nuances of the private credit market, KPMG stands as a trusted partner, guiding clients through the complexities of this dynamic and ever-evolving landscape.

To find out how KPMG can help you, get in touch with Mark by clicking on his profile at the top of this article.

^{[1]  https://www.bloomberg.com/news/articles/2024-06-27/sec-s-top-cop-concerned-about-private-credit-valuations-opacity}  

The views and opinions expressed herein are those of the respondents/authors and do not necessarily represent the views and opinions of KPMG LLP, Cayman Islands.