Could Private Credit be the solution for income seekers?
Alternative investments are increasingly being considered by investors in the search for returns, a key reason being potential diversification of overall risk at the total portfolio level. In this blog post, we'll look specifically at private credit, addressing the growth in private credit markets and some of the reasons behind their growing relevance in the marketplace.
A growing opportunity set
Providing loans to companies has historically been one of the main components of commercial banking activity. However, bank consolidations that began in the mid-1990s and regulations that followed the 2008 Global Financial Crisis (i.e., Dodd-Frank, Basel III) have led to reduced lending activity to small- and medium-sized companies. And while traditional financing sources have retrenched, capital from private credit funds has filled the void, marking a decade of significant growth with total private credit assets under management (AUM) rising from $237.9 billion at the end of 2008 to $848 billion at the end of 2020. Private credit AUM is expected to grow even further over the next several years, reaching a projected $1.46 trillion at the end of 2025.1
Private credit comes in many forms, but most commonly involves non-bank institutions making loans to private companies, based on the cashflows generated by the respective business, for the acquisition of a hard asset (e.g., real estate) or acquiring existing loans on the secondary market. Examples of different types of loans include:
- Senior debt – a loan that will be repaid first if the borrower defaults
- Subordinated debt - a loan that is repaid after senior debt in the event of bankruptcy
- Unitranche debt – senior and subordinated debt combined into one loan
- Mezzanine – a form of financing that combines debt and equity
The investment rationale
We believe private credit offers distinct investment benefits, including:
SUPERIOR PERFORMANCE POTENTIAL RELATIVE TO PUBLIC FIXED INCOME
Private credit has outperformed its public counterpart (Credit Suisse Leveraged Loan Index) in 20 of the last 20 vintage years by an average of 5.48%, according to data from Hamilton Lane.2 The current market environment also highlights the potential for outperformance on a go-forward basis given the available risk premiums in direct U.S. middle market loans, which is estimated to be between 2.3% and 3.4% above that of broadly syndicated loans.
Private markets represent a large investable universe. For example, in the U.S. there are over 17,000 private companies with annual revenues over $100 million, versus approximately 2,600 public companies with the same revenues. By this measure, investors only allocating to public markets are limiting their opportunity set to just 15% of the largest firms in the U.S.3
Private credit offers less volatility relative to public fixed income such as bank loans and high yield, given that loans are not publicly traded and are typically valued on a quarterly basis. As such, they are not subject to the technical market moves experienced by investments with daily market-to-market pricing.
Private credit also offers investors greater downside protection as they are typically higher in the capital structure and have strong covenants, including lender protections requiring companies to meet certain financial conditions - such as debt/EBITDA or interest coverage ratios. Even in the event of default, the average recovery rate for U.S. middle market senior loans between 1989 and 2018 was 75%, which was significantly higher than the 56% recovery rate for senior secured bonds.4
Finally, in times of negative calendar-year returns seen in high yield markets, such as 2008, 2015 and 2018, data shows that the Cliffwater Direct Lending Index outperformed the Bloomberg Barclays High Yield Index by an average of 13.26% each year.5
SHORTER DURATION RELATIVE TO PRIVATE EQUITY
The shorter average lifespan of private credit investments relative to private equity results in a quicker investment period and return of capital (often within a two-to-six year window). As such, investors who may be subject to liquidity constraints can still gain the benefits of private markets exposure, without having to invest in funds that have a 10-year term, as is the case with private equity.
The bottom line
As investors seek to address the challenges of generating returns, improving / protecting portfolios and mitigating downside equity risks via broader diversification - they are increasingly looking to utilise private credit in their asset allocation.
Ultimately, while each investor’s circumstances are different, and there is no one-size-fits-all solution, we believe it is a worthwhile exercise to consider various alternative allocations to private credit to improve potential outcomes.
¹ The Rise of Private Credit: Who, What, Where and Why, July 2020; S&P Global Market Intelligence, November 2020
² Hamilton Lane, March 31, 2021
³ Hamilton Lane, Broader Horizons: The Case for Private Markets Investing, April 2021
⁴ Oaktree Insights, Direct Lending: Benefits, Risks, and Opportunities, May 2021
⁵ Cliffwater 2021 Q2 Report on U.S. Direct Lending, June 30, 2021