What is private credit?
In a nutshell, private credit or private debt (terms frequently used interchangeably) is a loan provided by a non-bank lender that is often tailored to the borrower’s specific needs. Such loans are negotiated directly between the lender and the borrower, typically in amounts ranging from £10m to £250m and for terms between 3 and 7 years. Private credit typically pays a floating rate of interest that varies along with a reference rate. Importantly, private credit instruments are not traded on public markets and the bespoke nature of the loans make them difficult to sell prior to maturity.
According to Preqin, private debt as an asset class has tripled in size since 2008, to nearly USD 1.2 trillion (excluding real estate debt). This growth has been underpinned by the shrinking or even complete withdrawal of bank lending from certain markets and sectors following the global financial crisis (GFC). Since this withdrawal of bank lending, private credit has become a particularly vital form of financing for small and medium-sized businesses in the US and UK. The attractiveness of private credit for investors is driven by three key features of the asset class:
1) Income/return premium to equivalent liquid, public credit.
2) Defensive characteristics resulting in lower default rates and higher recovery rates than equivalent public credit.
3) Diversification benefits within a wider portfolio.
Direct lending is often made to small and medium-sized companies, otherwise known as the middle- and lower-mid market. Such companies are frequently shunned by banks and are too small to access the public syndicated loan market. These cash-flow based loans are typically senior to other forms of debt the borrower may be using, secured against a specific asset owned by the company (or a more general pledge of all the assets of the company), and embed lender protections in the form of financial covenants.
Two particularly appealing features of direct lending during a rising rate environment are the floating rate of interest and the shorter maturity of the loans compared to other forms of debt. The interest coupons on private debt are usually reset higher every 90 days so, as the central bank (such as the Bank of England or US Federal Reserve) raises its base interest rate to combat inflation, private debt coupons are also increased. In addition to increasing an investor’s income, this feature also helps the loan maintain its value (price stability when the portfolio is valued). The shorter maturity of private loans means that investors have their capital returned more quickly and can therefore redeploy that capital sooner as the economic and investing environment evolves.
Real Estate Debt
Private real estate debt has many features in common with private debt (described above): floating rates of interest, lender protections, and short maturities, for example. Importantly, the collateral to a secured real estate loan is the property the loan is being used to finance. As we have written elsewhere, real estate has historically proven quite resilient during times of rising interest rates and inflation. So real estate loans, already boasting floating rates and short maturities, offer the additional benefit of being secured by an asset that has traditionally performed well during inflationary periods, giving the lender confidence that in the event of default by the borrower, the collateral asset(s) will have an attractive resale value from which the lender can recover its loan.
As described above in the introduction to this issue, opportunistic credit is a flexible strategy that permits a manager to trade and invest in a wide range of debt securities as the economy evolves and opportunities arise. This can range from short-term investments in liquid public credit that has been sold indiscriminately by forced or panicked sellers; direct lending to companies in out-of-favour sectors where pricing and protections are at the lender’s discretion; purchasing cheap defaulted loans and working them out as part of a creditors’ committee. In short, opportunistic credit is a go-anywhere strategy that pursues investments offering the best reward-to-risk that is particularly well suited to periods of heightened economic uncertainty and market volatility.
To successfully implement an opportunistic credit strategy an investment manager must possess a large investment team with wide-ranging credit skills and the origination network to source a broad range of opportunities. At a macro level, this strategy demands strategic thinkers willing to pivot quickly as the market evolves to maximise investment performance.
Private credit is a very broad category with features and characteristics that have driven ever-increasing demand over the past 20 years. Institutional investors allocate to private credit for many reasons, from its high-quality income and floating rate coupons to its defensive credit characteristics that often result in lower risk compared to similar public credit. In combination with traditional and alternative asset classes, private credit is also a very effective portfolio diversifier that more than justifies its inclusion throughout the investment cycle.
However, at times like these it can be difficult for investors to step back and take a long-term, big-picture view of their asset allocation when they have immediate concerns about their portfolios. The investors we have spoken to lately are worried about inflation and rising interest rates eroding value in their portfolios so we have redoubled our efforts to understand which asset classes and strategies will likely do well in these challenging markets and find great managers that pursue them.
We favour direct lending, real estate debt and opportunistic credit in the current environment and will be adding funds in these strategies to the platform from top global managers in the coming months.