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Private credit: Tipping point

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21 Apr 2022

With central banks about to start their first round of monetary tightening, is the easy money that has fuelled private credit’s exponential growth about to dry up? Mona Dohle takes a look.

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With central banks about to start their first round of monetary tightening, is the easy money that has fuelled private credit’s exponential growth about to dry up? Mona Dohle takes a look.

What do Australian Waste Services, US technology firm Bus Patrol and, perhaps soon, Chelsea Football Club have in common? The first two are part-financed by some of the world’s largest private credit funds, while the latter is the centre of discussions with private credit giant Oaktree Capital Management after Roman Abramovich’s assets were frozen.

Two decades ago, unlisted mid-sized firms might have approached banks directly for funding. But in the aftermath of the global financial crisis, banks drastically reduced their lending activities and so private lenders stepped in. The global private credit market is now worth $1.2trn (£900bn) and growth forecasts by 2026 range from $1.5trn (£1.1trn) by Moody’s and $2.69trn (£2trn) by Preqin.

And while most institutional investors would not like to see themselves as shadow bankers, their lending activities have become a cornerstone of the market. In the UK, pension funds account for more than 9% of non-bank financial intermediation, according to the Financial Stability Board.

If indirect investment through asset managers is considered, the number is significantly higher. Preqin estimates that public sector pension schemes now account for some 20% of private credit investments globally, with another 10% held by public pension funds. Insurers and charitable foundations are also significant players with 13% and 9% stakes.

Private credit has taken a growing share of pension fund portfolios with private credit allocations among defined benefit (DB) schemes grew to 21% from 16% during 2021, according to Mercer. And some 20% of schemes told the consultancy that they intend to continue to increase exposure.

Alternative income

The appeal of private credit, particularly to mature defined benefit schemes, is clear. It offers a steady stream of cash at a time when traditional bonds have turned from fixed income to no income. As such, private credit has become a popular element of growth-oriented portfolios and is commonly used in liability driven investing (LDI) strategies.

Some larger funds, such as USS and the Pension Protection Fund (PPF), have established in-house research capacity to access the sector. “We have split private credits into parts,” says Purna Bhudia, the PPF’s head of credit. “Part of our private credit portfolio has been in-sourced, but we also use external managers because we understand that we will never have the breadth to cover everything.”

“When looking at private credit, we first established our goals at the PPF and then matched our investment positioning to meet these goals,” Bhudia says. The fund uses a combination of investment grade private credit on a buy-and-hold basis as part of its LDI strategy and high-yield private credit in its return oriented profile, which is externally managed.

Other pension funds, such as local government pool Border to Coast, have opted to outsource their strategy. The £55bn pool announced more than £500bn in private credit investments in May last year, spread across six external managers, followed by another £208m investment in private credit at the beginning of this year, suggesting that the appetite for private lending among its partner funds continues to grow.

London CIV, another local government pension pool, also sees increased demand for private markets among its partner funds. The pool has launched four private market funds during the past year and another £92m private credit fund at the end of March.

Are these funds concerned about the impact of monetary tightening? Bhudia stresses that private credit might not be directly affected. “Private credit in itself remains attractive first because the risk-adjusted returns are steady and you get an illiquidity premium but you also get access to securities, such as secured property loans, that you would not get in the public market. “We are cognizant that there will be more volatility as we figure out how the central banks will move in this environment,” she stresses.

Evan Guppy, head of LDI at the PPF, says that the fund uses private credit as a hedge. “What happens is that we will match our liabilities to what we are expecting to pay our pensioners. If interest rates move, our liabilities move too. “That’s why interest rates do not matter as much because even if the asset values move, our liabilities have also moved to an equivalent amount,” he adds.

Private credit also plays an important part in hedging against inflation risks at USS, says chief investment officer Simon Pilcher. The £82.2bn fund has expanded its private markets team to 60 people and invests in a combination of infrastructure, private equity and debt.

Dry powder

An indication of investor appetite are the extraordinary levels of dry powder. By the end of 2021, the level of capital that is yet to be deployed sat close to $400bn (£303bn), accounting for almost half of the world’s private credit allocation, according to Preqin. The data provider stresses that high levels of dry powder are not necessarily a cause for concern. In the immediate aftermath of the global financial crisis, the level of capital yet to be invested surged between 2010 and 2012, but managers subsequently succeeded in deploying the capital.

However, the macroeconomic environment is different to how it was 10 years ago, with inflation on the rise, central banks raising interest rates and the mid-sized businesses commonly targeted by private market investors are already struggling with the effects of the pandemic.

But perhaps the biggest and least mentioned concern with high levels of dry powder is its impact on returns. It is all well and good if ever growing numbers of capital are deployed with an ever shrinking number of asset managers. But if that cash does not result in additional funding for businesses like Bus Patrol, returns will be hit. And returns have slumped, as Preqin’s data shows.

Private credit’s internal rate of return has fallen from double-digit figures 10 years ago to low single digits during the past three years. Grant Murgatroyd, senior writer at Preqin, warns that this has been camouflaged by increasing leverage. “Over the past couple of years, debt funds have sought to add some juice to these lacklustre returns, either by leveraging the fund itself or by taking on broader exposure through the capital structure.”

Systemic risks

Ever mounting levels of dry powder have turned private credit in to a borrower’s market. Ratings agency Moody’s warned in a report at the end of last year that “systemic risks” had built up in the sector. The ratings agency warns of a deterioration in credit quality combined with a rise in leverage.

“Competition between public, institutional and private markets has lowered loan credit quality and allowed for increased document flexibility, diminishing credit protections for investors,” the report read. “In particular, leverage has risen, which increases downside risk when economic conditions weaken, while rising shares of distressed companies can weaken productivity and lead to misallocation of capital to unhealthy companies.”

The ratings agency also warns of the increasingly blurred boundaries between private equity and debt. “The decline in leveraged finance credit quality is driven by the aggressive financial policies of private equity sponsors,” the ratings agency warns. Moody’s estimates that within the distressed debt universe, some 70% of debt is owned by private equity firms. It also highlights that among the top 12 private equity portfolios in the US, all firms had a leverage of six times their average earnings before EBITDA.

The market has also become increasingly concentrated, geographically and in terms of players, particularly at the lower end. Some 61% of all private credit is held in the US and four of the 10 largest private credit funds swooped up some $16bn (£12bn) of the $23bn (£17.4bn) in distressed debt deals.

The systemic risk lies in the combination of these two factors, increased leverage and fund manager concentration, warns Moody’s, as the defaults could spark a domino effect.

Digging deeper

Does all this mean that pension funds should stay clear of private credit? The PPF’s Bhudia stresses the importance of bottom-up research and having realistic expectations in terms of liquidity. Because the PPF invests in investment-grade debt on a buy-and-hold basis, liquidity is less of a concern. But this also requires thorough research of the companies the PPF invests in.

“We use models which mirror those of rating agencies to get a risk assessment of the firms we invest in and use that in the sectors to match with public comparators. We assign a credit risk rating to all assets we invest in and that is constantly evaluated,” she says. “We will spend a lot more time before we invest in private credit to make sure it is completely safe. For the investment grade side, the reporting requirements are embedded in the loan documentation, so we know exactly what level of information to expect,” Bhudia adds

“Our experience is that it is far easier to access information because we are often a principal lender, or a significant lender. But you cannot just wait for the annual accounts to come up. If you ask the questions, you will usually get a response.”

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