Private credit is the subject of much discussion in the City and beyond. This comes within the backdrop of an evolution in the financial markets where alternative investments are becoming a significant focus. This has placed private credit centre stage. Indeed, it has emerged as a zeitgeist investment, amassing nearly $1.5trn (£1.16trn) in assets globally.
One of the key attractions for more long-term focused investors is that private credit looks set to be an area that may gain from the pressure on traditional banks and tighter credit conditions.
“Private market lenders have been taking market share from the banks over many years, but the pace of bank displacement has quickened since the Covid period,” says Linda Desforges, private credit portfolio manager at Border to Coast.
Expanding on this point, she adds: “Private equity sponsors with companies that are focused on growth see the advantage of borrowing from private credit providers who can offer a tailored solution to the borrower, close transactions with speed and provide additional flexibility if required.”
Much of this is connected to a new, more uncertain economic and political environment, where banks and regulators are more cautious. This can be seen by the tightening of standards in the US as highlighted in a first quarter survey of senior loan officers.
A narrowing market
Desforges places these developments in context. “The 2023 banking crisis, with the demise of SVB, Signature, Credit Suisse and First Republic Bank, added further pressures, at least on a temporary basis.
“This led to a narrower banking system, where banks prioritise healthy capitalisation ratios rather than creating new loans,” she says, adding that tighter credit conditions are “supporting the attractive pricing environment currently available in private credit”.
Stéphan Caron, head of EMEA private debt at Blackrock, broadly concurs with this picture. “Traditional banks will continue to play a vital role in the financing of economies, but private debt funds will continue to gain a higher share of the funding pie,” he says.
This is all within the wider perspective of the private credit market being robust. A perspective highlighted by Lushan Sun, private credit research manager at LGIM Real Assets. “The private credit market has generally been resilient this year,” she says. “The investment grade and crossover space has seen decent deal flow, pricing discipline, strong premium and, not forgetting, a higher yield environment.”
Here, when discussing the banks, she says that it is important to “note that tighter credit conditions and bank retrenchment is likely to accelerate the shift towards private market financing”.
Jo Waldron, head of client and solutions, private credit at M&G, reinforces the view that the banking situation will benefit the asset class. “Private credit looks set to benefit as banks continue to retrench from credit markets,” she says.
“This continues the trend seen post the global financial crisis, with banks’ willingness to lend being further curtailed by the macro-economic downturn and cautionary demise of Credit Suisse alongside a handful of smaller US banks.”
For private credit this creates a wider opportunity set to step in with customised funding streams “for borrowers with lender interests at heart”, she adds. Different regions also offer different opportunity outlooks. In the US, there have been some interesting developments. Caron points to the widely anticipated contraction in bank lending, which could provide two tailwinds for private credit, especially direct lending.
“For one, an expansion of the addressable market of potential borrowers, including in the upper middle market. Then there is enhanced pricing power versus the public markets, reflective of the certainty of execution that private credit provides,” he says.
In Europe, Caron continues to see wider adoption of private debt, in particular across Germany, the Benelux and the Nordics.
A step back in time
But there is another perspective. As private markets are complex, with some often having high levels of risk and volatility, they are therefore not suitable for all investors. Nevertheless, how should investors approach private credit given this aspect to it?
The answer for Caron is simple. “Investors have in recent years turned to asset classes such as private credit for income in a low-rate environment,” he says. And he shifts the risk debate to the appeal of the asset class. “Even as many central banks raise interest rates, the appeal of these assets persists,” Caron says.
He expands on this point by adding: “While higher rates bode well for yields in public markets, they also portend even potentially more attractive returns for private debt holders across the spectrum of financing options, as many deals have floating-rate structures that lead to higher yields as rates rise.”
One of the key drivers for the increased allocations to private credit is the low volatility versus public markets in addition to the attractive returns. Caron believes that he may have seen something like this before.
“The weak performance and market structure challenges in liquid fixed income with mark-to-mark dynamics is accelerating the barbelling approach toward passive and private assets – in the same way we saw in equities 10 years ago – with a shift from active liquid allocations in favour of private equity allocations – whereas fixed income is still in the early stage of this evolution,” he says.
A vast universe
For Desforges, it is pension pools like Border to Coast which have spurred on facets of private credit. The direct lending market: senior secured/uni-tranche debt, which is the most senior part of the capital structure with a relatively low level of risk and volatility and where the strategies are the least complex, is estimated to be worth $1trn (£780bn) and has been funded primarily by insurers, pension funds, endowments and sovereign wealth funds.
There are barriers to entry in terms of making a £500,000 minimum commitment and more sought after managers can be hard to access. Waldron makes the point that at one end of the spectrum, pri- vate markets can be as complex as signi cant risk transfers, or fairly simple lending mechanisms such as leverage loans. “What they do consistently o er is an opacity and skill premium,” she says.
Therefore, the benefits for including private capital in a portfolio are significant. “Given the breadth of the sub-asset classes within the universe, we believe private markets can offer investors unique diversification opportunities to help complement their existing portfolios,” Waldron says.
Indeed, the range of options within the private credit universe is another part of its appeal, as it ranges from private corporate lending to consumer finance, real assets lending and structured credit – all of which have different underlying risks and performance drivers.
“Some are liquid, others are illiquid, some are investment grade, others high yielding, but most are cash flow generating propositions,” Waldron says. “This provides opportunities for investors seeking a secure stable income stream returns at different stages of the cycle.”
Waldron also highlights an important point that gaining entry to the private credit universe needn’t be a challenge for investors. “As private markets continue to grow and develop, improved accessibility via a semi-liquid fund structure, and wrappers such as European long-term investment funds and long term asset funds are helping to redefine alternatives and opening the doors to unique opportunities across the private credit spectrum,” she says.
In addition, it’s important to note that there are two distinct markets within private credit – investment grade and high yield. “Investment-grade private credit has demonstrated its resilience over several economic cycles,” Sun says. “High yield private credit – which includes direct lending – has a more limited track record as the asset class grew significantly in benign market conditions after the global financial crisis.”
Sun, therefore, sees credit risk as becoming a more dominant driver in the coming months, as investors renew their focus on fundamentals, making asset selection critical. “Thorough due diligence, pricing discipline and stress testing in place are all essential to delivering strong long-term returns in private credit in our view,” she says.
The recent re-pricing in private credit serves as another opportunity for investors. “Yes, we believe private credit is attractive,” says Desforges, reinforcing the re-pricing narrative. “For the lower risk direct lending strategy, the gross returns available have risen from around 8% in the first quarter of 2022 to around 11%, which has been driven by a move up in interest rates and a widening of credit spreads.”
But there are issues. The net return, after fees and expenses, will be lower, while managers are factoring in higher than historical losses. However, Desforges, says: “The net return will still likely be an attractive 8% to 9%, which compares well against the 6% net return that was anticipated for the strategy in early 2022, with a lower level of assumed losses.”
For Caron, the re-pricing has created some complexity. “As we attempt to balance the narratives from multiple economic and market indicators, for allocators this creates a complex investing environment, which argues for focusing on quality companies with sustainable cash flows in defensive sectors,” he says. Long-term “mega-forces” still offer investment opportunities, he says. “Be that in healthcare, digitalisation or in the transition to a low-carbon economy.
“And we also continue to see attractive opportunities to finance, buy and build platforms in sectors ripe for consolidation, particularly in Europe,” Caron says. Moreover, yields are attractive relative to the historical average, thanks to rising base rates.
But Sun says: “The macro uncertainty means that investors are increasingly cautious and selective, and rightly so in our view. For the time being we are maintaining our up-in-quality stance, favouring higher credit quality and defensive issuers.”
Interestingly, the cherry picking by investors has led to growing divergence between defensive issuers and weaker, more cyclical issuers that need to offer better terms to attract interest. “This is somewhat different to the public bond market where spread dispersion across sectors is low within investment grade, with the exception of financials versus non-financials,” Sun says.
Diversified and stable
Jo Waldron goes further, saying that with interest rate rises and ongoing volatility defining the new normal, private credit should be seen as an attractive source of diversified, stable income and uncorrelated returns.
“Recent dislocation and dispersion across credit markets pro- vide an attractive entry point for investors, especially as lenders need flexibility and are willing to compensate lenders for this, leading to increased yields on offer for essentially the same credit risk,” she says.
Furthermore, private credit’s often floating rate nature embeds a level of inflation hedging in the return stream. “In the current environment it is able to offer real yield in comparison to traditional credit classes which struggle to generate real income returns above high single-digit inflation,” Waldron adds.
The attraction of private credit is therefore impressively wide ranging. “We now see a broader client base outside of purely institutional clients, such as wholesale and individual investors, looking to these more flexible structures to access assets which were historically only available through closed-ended funds, as they seek stable, long-term diversified portfolios,” Waldron says.
How, therefore, should pension funds respond? “Bearing in mind that portfolio managers always tend to be biased towards their own asset classes, I would comment that pension funds should have a good level of exposure to private credit,” Des- forges says. “And any that are under-exposed should be looking to increase their allocation.”
Defined contribution schemes could consider short-term alternative finance for its flexibility as part of a portfolio as members approach retirement, Sun says. “The short-term nature of the underlying loans you can target, coupled with maturity diversification, means that cash could be returned to the investor over a short period, with regular liquidity being generated,” she adds.
Come on Rishi!
Going forward, the asset class is expected to deliver a good real return after inflation – assuming Rishi Sunak’s ambition on inflation is successful – and here direct lending offers strong downside protection and low volatility. “The illiquidity premium available to investors from private credit makes the asset class compelling for pension funds,” Desforges says.
Investor opportunities are, therefore, abound. “Riskier private credit strategies that offer credit solutions to companies that are facing distress are also offering good returns, but the lower risk part of the private credit spectrum perhaps offers the best risk-reward opportunity currently,” she adds.
Not stopping there, Desforges also notes that asset-backed strategies are also attractive, albeit within commercial real estate debt their focus is on managers lending to the highest quality assets across the globe and have little exposure to office or retail. “Asset-backed strategies are also looking attractive, such as those focused on mortgage lending, SME lending, intellectual property, etc,” she says.
Sun offers another insight given that interest rate rises have peaked. “As we approach the end of the hiking cycle, we believe duration looks more attractive and we will continue to seek opportunities to lock in long-term fixed-rate assets,” she says. “The refinancing pressured faced by real estate debt borrowers may also present a window for investors to step in and provide financing on attractive terms, and we prefer resilient sectors such as residential and industrials.”
This all adds up to private credit not just being talk, but an investment zeitgeist with substance.