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Private Credit Investing: Opportunities and Considerations

Private credit investing has emerged as a dynamic and increasingly popular asset class within the private capital markets. We are incresingly working with our clients on assessing and understanding the intricacies, potential benefits and risk of private credit investing.


What is Private Credit?


Private credit refers to non-bank lending where funds are raised from investors and loaned directly to companies. These funds, often managed by private debt funds, provide loans to businesses that may not qualify for traditional bank financing due to their credit profiles or specific funding needs. Private credit can encompass a variety of debt instruments, including senior loans, mezzanine debt, and distressed debt.


It is important to keep in mind that the term "private credit" enompasses a wide range of investing strategies. The below chart highlights some examples of this variance in exposure and strategy type.


Growth and Market Trends


Private credit has become one of the fastest-growing segments in the private capital market, with approximately $2 trillion in assets under management (AUM) as of 2023​​. This growth has been largely driven by investors seeking higher yields compared to traditional fixed-income investments and the flexibility private credit offers to borrowers.


Institutional investors, including university endowments and pension funds, have significantly increased their allocations to private credit. For example, the University of California’s $100B AuM pension and endowment funds have shifted from hedge funds to private credit, reflecting the broader trend of growing interest in this asset class​​. (University of California to Dump Hedge Funds for Private Credit)



Why do some borrowers choose Private Credit Over Traditional Bank Lending?


Flexibility and Customization - Private credit offers more flexible and customized loan terms compared to traditional bank loans. This flexibility is particularly beneficial for mid-sized firms with specific funding needs that banks may not be able to accommodate​​.


Speed of Execution - Private debt funds can often execute loans more quickly than banks, which is advantageous for companies needing rapid access to capital. This agility makes private credit an attractive option for firms in sectors like technology and healthcare, which often require swift financing solutions​​.


Higher Yields - Private credit investments typically offer higher yields than traditional fixed-income securities. This is partly due to the higher risk associated with lending to less creditworthy borrowers, but it also reflects the illiquid nature of these investments​​.


How does private credit differ from traditional bank lending and private equity?


Banks engage in liquidity transformation: They take short-term deposits from savers and convert these deposits into long-term loans, operating as intermediaries between savers and borrowers. Banks often sell the loans to investors, a process known as syndication or securitization.


Private equity firms raise long-term capital from investors, typically high-wealth individuals and institutional investors like pension funds and insurance companies. The private equity firms then purchase equity in businesses, often buying entire firms.


Private credit funds—like private equity—raise capital from investors, but they make loans rather than buying equity. Most private credit funds are not leveraged, but a minority do borrow money or use derivatives to enhance their returns. Confronting competition from private credit funds, parent companies of some traditional banks, such as JPMorgan, have launched platforms to match investors with business borrowers.


Risk-Adjusted Returns


A critical consideration for investors in private credit is the risk-adjusted return. According to a study by Erel, Flanagan, and Weisbach (2024), private debt funds generally produce risk-adjusted returns that are competitive with other asset classes​​. The study found that while the gross-of-fee abnormal returns are positive, net-of-fee returns are typically aligned with the investors' risk-adjusted rate of return, implying that these funds are adequately compensating investors for the risks taken.


Comparative Returns of Private Credit Versus Traditional Fixed Income


Performance Analysis


Returns Comparison - The historical performance of private credit funds shows that they offer attractive yields compared to traditional fixed-income securities. For instance, typical private debt funds charge loan rates that are significantly higher than those available through banks, often exceeding 9-10%​​. This premium reflects the higher risk associated with lending to less creditworthy borrowers or those requiring rapid funding.


Institutional Survey Insights - A survey of CIOs from leading endowments revealed that private equity, including private credit, remains a top priority for institutional portfolios. This interest is driven by the potential for higher returns and the strategic benefits of diversifying away from public markets​​.


Asset Allocation Trends


There has been a clear trend among large institutional investors towards increasing allocations to private markets, including private credit. Data from top US university endowments indicate a significant growth in private equity (including venture capital) allocations from 20% in 2013 to 37% in 2023​​. This shift highlights the growing recognition of private credit as a valuable component of diversified investment portfolios.



The Pros and Cons of Private Credit Investing


Pros & Potential Benefits


  • Higher Returns: Private credit investments often offer higher yields compared to traditional fixed-income securities, providing attractive risk-adjusted returns.

  • Portfolio Diversification: Adding private credit to a portfolio can enhance diversification, reducing overall portfolio risk.

  • Customized Financing Solutions: Private credit offers flexible and tailored loan terms that can meet the specific needs of borrowers.

  • Rapid Execution: Private debt funds can often execute loans more quickly than traditional banks, providing timely access to capital.


Cons & Potential Risks


  • Illiquidity: Private credit investments are typically illiquid, meaning they cannot be easily sold or exchanged for cash.

  • Higher Risk: Lending to less creditworthy borrowers or those needing rapid financing can increase the risk of default.

  • Complexity: Private credit transactions can be complex, requiring thorough due diligence and careful management.

  • Regulatory Uncertainty: The regulatory landscape for private credit is evolving, and future changes could impact the market dynamics.


What to consider when conducting Due Diligence on Private Credit Investment Managers or Funds


  • Track Record: Evaluate the historical performance of the investment manager or fund, focusing on their ability to generate consistent returns and manage risk.

  • Management Team: Assess the experience and expertise of the management team, including their track record in private credit and their approach to risk management.

  • Investment Strategy: Understand the investment strategy, including the types of loans the fund focuses on, the sectors they target, and their approach to credit analysis and portfolio construction.

  • Fee Structure: Review the fee structure to ensure it aligns with your investment goals and provides value for the services offered.

  • Risk Management: Examine the risk management practices of the fund, including how they handle defaults, loan monitoring, and portfolio diversification.

  • Transparency: Ensure the fund provides regular and transparent reporting on performance, holdings, and any potential issues.


Does the growth of private credit pose risks to financial stability more broadly?


Global financial regulatory authorities have raised concerns about the potential risks of expanding private credit. The Bank of England's December 2023 Financial Stability Report identifies private credit and leveraged lending (loans to highly indebted firms) as significant vulnerabilities amid rising global interest rates. Meanwhile, the Federal Reserve’s May 2023 Financial Stability Report views the financial stability risks from private credit funds as low, partly because these investors must lock up their money for five to ten years, reducing the risk of destabilizing runs during stress periods.


Regulators are particularly concerned about the lack of transparency in private credit funds, which disclose less about their performance, loans, and investors compared to banks. This opacity limits regulators' ability to monitor connections between private credit funds and other financial system parts, such as insurance companies, potentially hampering swift responses during financial stress. The Bank of England noted in its December 2023 report that the opaque nature of private credit markets complicates risk monitoring in the UK and globally.


If firms borrowing from private credit funds default and investors lose money, the broader financial stability risks are typically contained—unless there are interconnected links with other financial system parts that could lead to spillovers. The U.S. Financial Stability Oversight Council's 2023 Annual Report warns that unexpected defaults by private credit borrowers could cascade through broader financial markets, affecting various market participants and potentially disrupting markets and tightening credit conditions.


Regulators worry that investors in private credit, many of whom may be new to lending to small and mid-size firms, might refuse to roll over loans during economic downturns. This could leave highly leveraged firms vulnerable and unable to refinance their debt, leading to reduced investment, employment cuts, or defaults, causing direct losses to lenders and other financial participants. The Bank of England cautions that significant losses could excessively tighten risk appetite, disrupting market functions and tightening credit conditions in the real economy.


The IMF’s Global Financial Stability Report acknowledges the benefits of private credit in providing long-term financing to firms too large or risky for banks and too small for public bond markets. However, it warns that the shift from national banks and transparent public markets to the opaque private credit sector creates potential risks. If private credit remains opaque and grows under limited oversight, its vulnerabilities could become systemic. The IMF urges authorities to adopt a more intrusive regulatory approach to private credit and mandate increased reporting by private credit funds.


What are we doing and what are we watching?


Our objective for Private Credit investments and allocations for clients is to maintain a diversified portfolio by avoiding managers or allocations towards highly cyclical, capital-intensive industries. Instead, we focus on investing in funds or managers in non-cyclical sectors like software, insurance, and residential services, which generally sustain cash flow through market cycles. Our research suggests that higher interest rates have pressured some Private Credit managers and funds, which in turn is increasing the demand for capital solutions to bolster balance sheets of those companies. We actively seek opportunities where managers or funds may offer this support at favorable rates.


We're closely monitoring default rates across the industry more broadly but do not yet see a bubble in the asset class. While rising rates have increased some companies' debt servicing costs by up to 50%, default rates remain relatively low globally relative to historical standards. As rates stabilize and decrease, older vintages will experience less strain. The overall economic health is crucial for maintaining stable cash flow and margins and companies to meet their obligations.


During the Covid-19 pandemic, private credit activity was strong. In comparison, 2023 saw a return to normal levels, with the asset class continuing to grow. We expect 2024 to support private credit further, driven by increased private equity activity, declining interest rates, and optimized capital structures.



DISCLAIMER


Royce Advisory Pty Ltd (ABN 43 622 402 706) is a Corporate Authorised Representative (CAR) of MB Capital Partners Pty Ltd (AFSL 536053). This article, commentary and discussion is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or particular needs. You should consider whether the information is suitable for your circumstances and where uncertain seek further professional advice.


This communication is based on information from sources believed to be reliable at the time of its preparation (June 2024). However, despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice and neither Royce Advisory or MB Capital Partners is not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.


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