PRIVATE credit may have started as a niche segment of the bond market, but it is fast growing in importance – thanks to its attraction both as an asset class with stable risk-adjusted returns and as a source of corporate funding.
For investors, it offers both alpha or additional yield, and an ability to tailor lending to meet a preferred risk profile. For borrowers, it helps to diversify sources of funding, particularly in the segment of the market dependent on underwritten and syndicated bank loans.
Private credit is a relatively new asset class, which began life as a source of liquidity when the global financial crisis of 2008 caused high yield and syndicated loan markets to seize up. But it is already showing great potential.
The investment industry has some US$1.5 trillion in funds invested in private credit, albeit US$500 billion of that is in the form of dry powder – money yet to be deployed – according to Morgan Stanley. Demand has been growing at around 10 per cent a year in the past decade, broadly keeping pace with the much larger private equity segment. Overall, the market for private credit has the potential to grow to some US$3 trillion over the next decade, which is roughly 10 per cent of the US$37 trillion fixed income market, according to Bloomberg Intelligence.
Several trends fuel this growth. For one, tighter regulations make it more onerous for banks to lend to companies. At the same time, managers and owners of smaller and mid-sized companies are increasingly turning their backs on the equity market for finance. They may be wary of the regulatory burden of a public listing or don’t wish to dilute their own stakes.
These trends have emerged at a time when investors are seeking better ways to allocate long-term capital – that is, assets with equity-like returns but without the volatility, and with fixed income-like yield stability but without duration risk.
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A capital solution
Investors are drawn to private credit for a variety of reasons, not least of which is rising interest rates. Private credit, specifically senior direct lending, tends to be in the form of floating-rate loans. These tend to be attractive in an environment where central banks are tightening or keeping rates high longer than anticipated, which is the case today.
Because private lending locks investors in for longer periods, it offers an uplift over the yields available in public markets, depending on the level of risk.
Goldman Sachs research shows that private lending generated 10 per cent average annual returns from 2010 to 2022, compared to 4 per cent for high-yield debt and 3.2 per cent for leveraged loans.
What’s more, by being locked into their holdings for longer periods, investors are less vulnerable to the psychological pressure exerted by minute-by-minute market repricing. It protects them from a key source of underperformance – selling at the bottom. They can also benefit from the stricter lender-protection covenants than are typical in public markets, where the syndication of loans among investors tends to favour a lowest-common-denominator approach to investor protection.
For borrowers, the bespoke nature of the loan agreements provides more tailored solutions to capital requirements. Access to senior direct lending can prove a dependable source of capital that’s much quicker to raise than the traditional bank loan syndication process. Companies are willing to pay a premium for that access.
In cases where companies have secured long-term funding at lower rates, demand for fresh capital can be met with privately raised mezzanine debt. This avoids breaching most-favoured-nation clauses. These clauses force issuers to reprice any existing senior debt if the new issuance at an equivalent seniority is made at higher interest rates, so that existing investors don’t lose out. Some company owners also prefer mezzanine debt financing to issuing equity, because it prevents ownership dilution.
Specific risks, specialised skills
Although private credit offers investors the flexibility to mitigate risks, as with any bespoke contracts, loan agreements need to be structured carefully. At the same time, direct lenders need to understand the nature of the collateral, not least how to claim in the event of default and how to realise the value.
They also need to familiarise themselves with the intricacies of the markets the companies operate in. Some borrowers will inevitably fall on hard times. How portfolio managers deal with these periods to keep loans performing is crucial in generating excess returns.
Carefully constructed portfolios in which loans are diversified across sectors and geographies are a minimum. Given the locked-up nature of the capital, understanding their liquidity needs is paramount.
And given that private credit’s performance has historically been based on low and stable interest rates, the new era of higher, more volatile rates will prove a challenge as well as an opportunity.
Previously, many lenders were rewarded for taking on more risk when underwriting loans. Now, the rewards are more likely to accrue to lenders with rigorous credit analysis and the skills to structure loan agreements that offer adequate investor protection. Given the growing importance of private debt to the economy, regulation of the sector is set to tighten.
But with all that in mind, private credit can be an important source of returns at a finely tuned level of risk. For asset allocators, a market previously dominated by the banking system is now ripe for more mainstream adoption. The market is evolving to serve the financing needs of the real economy. This should give investors the choice between a highly diversified approach or specific risk-return profiles that suit their own risk tolerance or market views.
Here’s a look at private credit for all risk preferences:
- Direct lending: Senior debt where loans are typically secured by collateral and most often feature floating-rate coupons. These loans are made to support growth, acquisitions or general refinancing.
- Mezzanine debt: Subordinated to the senior debt but above equity. It will have distinct features, including warrants that allow for some participation in the performance of the company’s equity value. This carries higher risk than senior debt (there are mechanisms like payment-in-kind that help to reduce default risk), but should offer greater returns.
- Distressed debt: Encompasses loans to companies in a weaker financial or operational position. These companies may require restructuring to provide the best returns to the investor.
- Venture debt: Loans to early-stage growth companies with limited cash flow, but high future option value.
- Private asset-backed financing: Deals where the loan is attached to an underlying source of cash flow, such as car, aircraft and equipment leases. This real asset collateral helps to mitigate default risk. It is a private market upgrade on traditional asset-backed securities, which are bundled together and intermediated by banks and sold into the secondary market.
Shaniel Ramjee is senior investment manager and Andreas Klein is head of private debt, Pictet Asset Management
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