One silver lining in the current economy is the number of interesting bank debt deals available. As an asset class, bank debt is growing in popularity because of its relatively low risk, in terms of its position on the cap structure, and high returns, particularly when compared with other asset classes; such as equities, bonds or derivatives. In the current economic environment, asset prices are low, prompting many alternative asset managers to buy into distressed debt and other opportunities.

Alternative investment firms and other non-traditional lenders " which are able to act quickly to invest in the credit markets " are playing an increasing role in returning liquidity to the corporate lending market. Investors looking for high returns with lower risk exposure are seeking out alternative asset managers who understand and can handle investments in this space. Even funds that have traditionally traded non-credit assets are looking at ways that they can improve by adding a credit strategy to their portfolios.

Alternative investment firms are participating in the primary market, originating deals and acting as the agent, as well as the secondary market, where they are actively trading bank debt. In both cases, managers have several operational challenges. Funds that are originating loans must have the capability to handle the work involved with being a primary lender, including the asset management and loan administration functions, which require considerable time and effort. Often this means monitoring the deal through numerous metrics, periodic due diligence, restructuring the deal and potentially having to deal with workout situations with the borrower when things don't go right. Given the manual nature of this work, often funds will be forced to hire many people, with extensive experience and expertise, to perform these roles.

For funds participating in the secondary market, a significant operational consideration is how they will quickly settle and manage their positions to make sure the economics of their holdings are correct and that the agent properly reflects the funds position in the deal; for instance, funds have to process numerous updates from the agent and confirm that the agent has accurately administered the fund's portion of the deal. Because bank debt dealings are largely manual " involving fax and email " firms must figure out a way to improve the efficiency of managing their positions, maintain transparent exposure reporting and decrease operational risk.

For alternative asset management firms that invest in bank debt, last year's bank failures underscored the importance of standardizing the way they deal with agent banks so they can be sure they have an independent and accurate assessment of their position that are reconciled with the agents' books and records.

Agent banks may not always convey information in a timely manner, and the accuracy of the information is not always maintained throughout the distribution and acquisition of that information. Given the complexity of how various deal events are processed it is also difficult for funds to ensure that each of these activities is being processed consistently and accurately. As a result, managers need to design their operational processes to identify and correct errors quickly " before it negatively impacts the manager's portfolio. At the same time, managers must provide investors with greater transparency and assurances that their portfolios are properly valued.

Bank debt is a resource-heavy asset class to manage. Many alternative investment firms use manual, error-prone workflows, which creates inefficiencies as well as an inaccurate picture of a firm's holdings, exposures and P&L. Many firms are finding that home-grown systems, usually on spreadsheets, are no longer adequate for managing risk. Loan information is received from agent banks by email or fax, and must be entered into individual spreadsheets, and then re-entered into their portfolio management and accounting systems.

Firms are realizing that they can't manage an entire asset class in an uncontrolled, non-systematic manner; the risk is that they will miss a reporting error from their agent banks, or inadvertently introduce an error themselves when performing calculations or transferring data to other systems. The potential impact of an error can be severe: Without a true understanding of one's positions, a firm can get a skewed view of its holdings, may miss negative trends and won't be able to make balanced decisions about their other investments. Traditional investment banking methods of solving this problem " by throwing bodies at the process " is not an option for alternative investment firms.

Over the last five years, systems to manage bank debt have been evolving. Those firms that have chosen to graduate from spreadsheets have sought out more robust systems. However, the first generation of these systems generally are lacking in functionality to support common deal structures and terms, don't allow trading across asset classes and do not integrate with accounting, risk, compliance platforms.

The lack of integration with other platforms means that these systems may not reflect loan terms properly: Errors and inefficiencies are introduced by double entering information into multiple systems, and information can't be aggregated to view a firm's entire portfolio. The inability to trade across asset classes means that funds are left combining several potentially incompatible systems to get a complete view of their portfolio.

The second generation of bank debt systems, on the other hand, are fully integrated and can manage all asset classes, eliminating the need for double entry of deals and information into general ledger and portfolio management systems and provide a single consolidated portfolio view. On a firm level, newer loan systems also allow communication with management, front office, risk and other back office personnel to help settle and manage the entire process.

Firms need automatic and accurate calculation of various trade economics, and new technologies are now able to calculate delayed compensation, PIK interest and enhanced handling of default interest. Other capabilities now available include the ability to calculate projections of daily accruals and fees, improve the settlement process, alert of notifications, and manage daily cash flows, to proactively manage portfolios and perform common agent functions. Events such as paydowns, interest payments, etc., are monitored and early warning is given so the buy side is alerted if those events are entered in a timely manner or at all.

Conclusion

The financial crisis exposed major vulnerabilities in the way alternative investment firms manage their bank debt portfolios, as well as their agent, bank, borrower and counterparty risk. VAR analysis alone is not enough to properly determine a firm's risk.

The failures at agent banks revealed the vulnerabilities that exist when it comes to agent, market, borrower and counterparty risk, as investors find it difficult to confirm their positions and validate the value of assets they held. Firms need specific and targeted system capabilities such as integration and mapping with general ledger, accurate calculation of loan economics, and reconciliation to manage their positions effectively " and that information should be integrated with pricing and valuation tools, portfolio management and general ledger platforms.

As with most evolving industries many firms are working hard to provide a combination of services, networks and technology to help participants in the credit markets overcome many of the difficulties that are common today such as settlement, trade confirmation, clearing of cash, agent reconciliation and automated notice processing. As these providers mature their offering funds are going to look to a new generation of systems to find a way of easily taking advantage of these offerings in a way that integrates with their business.

Alternative investment firms are playing an ever-increasing role in the bank debt market, becoming virtual banks that are providing much-needed credit liquidity to the system. Institutional investors seeking higher returns will turn to funds that are able to manage portfolios well, and who can justify that the assets they hold are in fact, worth what they say they are.

John Rizzo is VP of Credit Products at Paladyne Systems