Best Practice Risk Management for Private Credit

This blog is written and published by S&P Global Market Intelligence, a division independent from S&P Global Ratings. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence credit scores from the credit ratings issued by S&P Global Ratings.

Private credit is a rapidly growing asset class that has garnered increasing attention over the past decade. Defined as non-bank lending where debt is not issued or traded on public markets, private credit primarily developed as a result of post-financial crisis regulations that made it costlier for banks to serve smaller, riskier borrowers. By the start of 2024, private credit had grown into a $1.5 trillion market, with projections indicating it will increase to $2.8 trillion by 2028.^[1] This expansion is not only due to the growing demand for credit but, also, as private credit extends beyond traditional direct lending into new and more complex asset classes.

However, this rapid growth brings with it a critical need for robust risk assessments. As the private credit market expands, the complexity and potential volatility of the sector present significant challenges for investors. While conditions in the global credit markets have been relatively supportive – with declining interest rates and soft landings in many developed economies – the lack of transparency, market data and regulatory oversight inherent in private credit introduces unique risks that demand careful management.

A Call for More Rigorous Risk Assessments

As we enter 2025, S&P Global Ratings expects global credit conditions to remain generally favorable, with expectations for reducing defaults and improving credit conditions. Companies have been proactive in pushing out debt maturities, reducing immediate liquidity pressures for many lower-rated borrowers. However, this optimistic landscape is tempered by the symmetry in information between public and private markets. Unlike their publicly traded counterparts, private credit instruments are often not subject to the same level of transparency or regulatory oversight. Only around 20% of private credit issuers are rated, further complicating the task of assessing and pricing risk.

This lack of transparency, combined with the rapid growth of the private credit market, underscores the urgent need for comprehensive and transparent risk management processes. The absence of easily accessible benchmarks for private credit loans and the illiquidity of these assets heightens the difficulty of risk evaluation. To navigate this evolving market, investors must adopt more rigorous and structured approaches to credit risk management, ensuring that risk management is as thorough and transparent as possible.

Getting Clarity Around Risk

From origination to surveillance, private credit managers need to bring together differentiated data, analytics, and workflows that empower them to source, evaluate, and oversee their portfolios with unparalleled clarity, transparency, and efficiency.

Private credit managers – whether big or small – should consider the following eleven best practices for risk management:

1. Generate transparent, defensible credit scores.^[2]
2.  Assess relative risk across asset classes in a consistent fashion.
3. Combine qualitative and quantitative drivers.
4. Apply leading benchmarks.
5. Consider environmental, social, and governance (ESG) factors.
6. Help investors meet regulatory requirements.
7. Actively manage portfolios.
8. Proactively monitor deterioration in covenant cushions.
9. Consider operational risk issues from poor recordkeeping.
10. Recalibrate models annually.
11. Use risk factors in valuations.

These best practices can be achieved with the use of Credit Assessment Scorecards (“Scorecards”), Credit Analytics, Climate Credit Analytics and private credit capabilities for portfolio management and administration by S&P Global Market Intelligence (“Market Intelligence”).

1. Generate Transparent, Defensible Credit Scores

Scorecards are easy-to-use tools that draw on a mixture of quantitative and qualitative questions in a check-box style to identify key risks in a consistent and repeatable way. They are fully transparent, providing the underlying logic and generating letter grade credit scores that are globally applicable, broadly aligned with S&P Global Ratings’ criteria, and supported by historical default data back to 1981. Scorecards are especially useful for low-default portfolios that, by definition, lack the internal default data necessary for the construction of statistical models that can be robustly calibrated and validated. They can also be used for a quick initial assessment to flag potential risks before doing a deeper dive. As off-the-shelf solutions, they eliminate the need for model creation and maintenance, and firms with their own models can use them to validate internal results.

2. Assess Relative Risk Across Asset Classes in a Consistent Fashion

Scorecards help identify and manage potential default and recovery risks of unrated private companies and transactions across a multitude of sectors. Seventy plus Scorecards provide broad sector and geographic coverage, including all major asset classes, governments, real estate, and project finance. This enables users to compare investments on an apples-to-apples basis, relying on a well-known and trusted ratings scale, probability of default (PD) measures, and estimates of loss given default (LGD).

3. Combine Qualitative and Quantitative Drivers

Point-in-time and forward-looking qualitative factors (e.g., management experience), along with converging trends, create a comprehensive picture of credit risk. Having a standardized approach for creating these qualitative factors enables consistent analysis year-to-year and across analysts. A Credit Assessment Handbook details the criteria, and the factors can be built into a database over time to see which ones are most important when doing a deal. 

Rigorous Methodology and Criteria Documents can also help educate limited partners (LPs). For example, if there is a net asset value (NAV) lending fund, LPs can see the criteria model it is based on, the risk drivers, and how it compares to a more familiar asset class.

4. Apply Leading Benchmarks

Private credit loans are illiquid due to the lack of a secondary market, making it difficult to benchmark performance. Comparing credit scores in the private credit market with 140 industry and country risk scores maintained in the Credit Analytics tool can help identify risks that might go unnoticed otherwise. In addition, available data on liquid assets can help evaluate similar illiquid counterparts.

5. Consider Environmental, Social, and Governance (ESG) Factors

Climate Credit Analytics transition and physical risk pathway modelling and sustainability credit risk factors in the Scorecard framework help enhance transparency and reporting, enabling a more rigorous integration of ESG considerations into fundamental credit analysis. ESG factors are considered in detail alongside the traditional credit analysis formalized in the Scorecards, enabling users to reflect the impact of material ESG factors on credit risk.

6. Help Investors Meet Regulatory Requirements

Using Market Intelligence outputs to maintain a database of credit risk scores can help investors efficiently respond to regulatory requirements, such as insurance company requirements for lower-volatility asset classes to adhere to Solvency II.

7. Actively Manage Portfolios

Private asset managers need to gain visibility and control over all assets in a portfolio, however, many struggle with portfolio monitoring. iLEVEL empowers users to perform detailed analysis and reporting across their entire private market investment portfolios. With capabilities across asset classes – including private equity, venture capital, real estate, and private debt – iLEVEL helps firms manage the flow of data and create a single source of truth to make informed decisions. Users can answer questions about exposure to specific industries and geographies, drilling all the way down to the private asset or portfolio company level. 

8. Proactively Monitor Deterioration in Covenant Cushions.

While the appeal of private markets is becoming mainstream, the requirements are not. Private debt is unrated and less liquid, and the terms are more flexible, all of which add to its opacity and unpredictability. As a result, a manager's diligence in credit surveillance is a central consideration for investors. Covenants protect an investment by ensuring that the borrower adheres to a set of conditions that are designed to minimize credit risk. Advanced covenant monitoring plays a pivotal role in early detection of potential covenant breaches, enabling lenders to practice proactive management to avoid costly defaults and foster close relationships between lenders and borrowers. Market Intelligence’s Covenant Monitoring Service ensures stringent adherence to lending arrangements, while pre-emptively identifying and mitigating risks, thus safeguarding against costly defaults.

9. Recalibrate Models Annually

Annual recalibrations handled by Market Intelligence specialists ensure that the Scorecards and Credit Analytics models maintain industry leading performance that is highly predictive of default risk.

10. Consider Operational Risk Issues from Poor Recordkeeping

Poor recordkeeping poses significant risks for businesses, including potential compliance and security issues and operational inefficiencies. Market Intelligence’s WSO Software is a leading suite of capabilities for portfolio administration that provides a single platform with functionality for performance analysis, compliance, accounting, and reporting. Highly customizable reports, postings, and adjustments are designed for flexible accounting formats, as well as easy ingestion by leading accounting systems.

11. Use Risk Factors in Valuations

The valuation of private credit assets, especially illiquid debt instruments, performed by Market Intelligence valuation experts, can be combined with the Scorecards to gain a robust framework around tracking fundamental company performance over time. This provides independent fair valuations, comprehensive assurance reviews, and in-depth risk assessments.

A Comprehensive Solution to Credit Risk Management

To effectively manage the risks inherent in private credit markets, investors and asset managers need a comprehensive suite of tools, data and expertise. S&P Global Market Intelligence provides a robust framework for risk management, offering credit analytics, portfolio management tools and in-depth risk assessments that empower private credit managers to make informed decisions.

In an era of rapid growth and increasing complexity, the ability to manage credit risk with clarity and precision has never been more critical. By adopting best practices and leveraging advanced tools, private credit investors can navigate the evolving landscape with confidence, safeguarding their portfolios, and maximizing returns.

^{[1] “Understanding Private Credit”, Morgan Stanley, June 20, 2024, https://www.morganstanley.com/ideas/private-credit-outlook-considerations.}

^{[2] S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence credit model scores from the credit ratings issued by S&P Global Ratings.}