Private Credit: An All-Weather Asset Class

When the 2008 Global Financial Crisis struck, the U.S. Federal Reserve responded by nailing interest rates to the floor. Starved for yield, fixed-income investors gradually looked beyond publicly traded government securities and corporate bonds for relief. Since then, the market for private credit has exploded in size, diversity and complexity. Between 2010 and 2022, assets under management grew at a 15% compound annual rate, with the total—including commercial real estate and infrastructure debt—now roughly $1.9 trillion (see display).

Investors Have Flocked to Private Credit

Global Private Credit Assets Under Management ($ Billions)

Source: Preqin. Data through December 2022. Real asset debt includes real estate and infrastructure.

Now comes a new economic regime: Central banks are no longer subsidizing rock-bottom interest rates and the cost of capital continues to rise in dramatic fashion, creating ripple effects throughout the economy, including within the banking sector, during which time private creditors often stepped up to provide valuable capital to companies. More broadly, as both retail investors and private-credit providers can attest, there is finally “income” in the broad universe of fixed income. Moreover, we believe the case for private credit remains particularly compelling—both in terms of historical returns and current yields.

Direct Lending Has Outpaced Other Credit Sectors

10-Year Annualized Total Returns

Source: Bloomberg. U.S. Investment Grade Aggregate Bond Index, Credit Suisse Leveraged Loan Index, ICE BoA High Yield Index and Cliffwater Direct Lending Index. As of July 1, 2023.

Key Themes

While we believe the outlook for private credit continues to be bright, uncertainty remains elevated and economic headwinds persist, including inflationary pressure, the potential for an extended period of higher interest rates and geopolitical turmoil. Diversifying into private credit can tap into differentiated exposures and return streams to help navigate this challenging environment.

As we continue to evaluate the private credit market’s rich opportunity set, a few key themes have emerged:

1. Quality bias: As below-trend growth and higher rates threaten to expose cracks in weaker balance sheets, we believe providers of private credit should strive to stay high in the capital structure while focusing on quality companies in defensive sectors that have the potential to generate strong near-term cash flow.
2. Liquidity support: Although market conditions eased in the beginning of 2023, liquidity is still relatively tight and central banks remain committed to higher rates. Some sectors have really felt the pinch—proving an opportunity for private providers of capital to step in.
3. Inflation insulation: As elevated prices threaten to apply further economic pressure, we believe asset-based lending (where loans are backed by collateral) has the potential to provide a partial hedge against inflation because the collateral can also rise in value.
4. Diversification: Economic cross-currents could lead to greater dispersion within and across asset classes, reinforcing the value of looking for opportunity across a wide range of borrowers and income-producing sub-sectors and skillfully pivoting among them to maximize risk-adjusted returns.

True Quality

In typical direct-lending arrangements, investors make loans directly to midsize companies and, increasingly, to larger ones, too. These loans are often floating-rate, offering a potential hedge against inflation, as well as senior-secured—perched firmly atop the capital structure and well-guarded by covenants to help preserve capital.

As traditional lenders continue to retrench in the wake of macroeconomic uncertainty, we believe direct lenders can build resilient portfolios with stable cashflows by lending to high-quality companies at better risk-adjusted terms than available from broadly syndicated loans or high-yield bonds.

What does “high quality” mean? In our view, it generally implies that companies are demonstrating steady or improving revenue growth, as well as profit margins¹ in excess of 25%. In addition, we think investors should focus on companies with market-leading industry positions, exceptional management teams and reasonably forecastable business models in defensive industries, such as software, health care and business services. As a prudential measure, we believe that periodic stress-testing under a variety of economic and interest rate scenarios is appropriate.

But focusing on quality doesn’t necessarily demand settling for overly modest returns, in our view. In what we believe is a new economic regime marked by resurgent volatility, we find that high-quality companies have been willing to borrow at steeper rates to attract financing. Throughout the first quarter of 2023, the typical yield to maturity on direct-lending transactions (including original issue discounts, or OIDs) was approximately 12.0 – 12.8%, or 1.4 – 2.2 percentage points higher than the JPMorgan public loan index.²

Helpful Hydration

When liquidity dries up, attractive opportunities can emerge further down in corporate capital structures, sometimes in privately negotiated instruments that may be lower in creditor priority than senior debt but higher than equities. Suppose, for example, that a large private equity sponsor borrows at a low floating rate to buy a high-quality, fast-growing company. Assume, too, that the company will need access to additional capital to meet its strategic growth targets. Suddenly, rates spike and the market slumps, leaving the sponsor with little room to take on more cash debt or raise incremental equity at a high-enough valuation, ultimately jeopardizing those long-term growth targets. Meanwhile, potential exits—in the form of a strategic sale or an IPO—have slammed shut.

In this increasingly common scenario, providers of custom capital solutions have been able to supply welcome liquidity at significantly favorable terms. In recent months, we have found that structured capital—even for premier assets held by blue-chip private equity sponsors—can command contractual yields of 16 – 18%, with additional upside through warrants and other “equity kickers.”

This trend, we believe, is not likely to slow anytime soon. As the Fed hiked interest rates to stem inflation, sponsor issuance of high-yield bonds and leveraged loans fell 73% and 67%, respectively, between 2021 and 2022. Now, many large direct lenders remain cautious about the impacts of a potential recession; at the same time, buyout activity has slowed. In our view, these dynamics will continue to create opportunities for thoughtful private capital providers—especially those with longstanding relationships with private equity sponsors and with disciplined underwriting processes.

Opportunity in Asset-Based Lending

Depending on the assets involved, the use of collateralized debt can help to insulate portfolios against inflation.

The investment thesis of a traditional corporate bond is typically based on a company’s potential cash flow and enterprise value. In contrast, asset-based loans (ABLs) are primarily backed by an array of collateral—from accounts receivable and small business loans, to inventories and equipment. All else equal, liquid collateral (such as investment securities) can be safer than physical assets that aren’t as readily converted to cash in the event of default, and can offer stable return potential, as well as a built-in hedge against inflation.

We believe compressed equity valuations and economic uncertainty continue to bode well for this asset class. Under rosier market conditions, companies looking to expand their operations or fortify their balance sheets might seek to raise additional equity to meet those strategic goals. Instead, we continue to see opportunities for investors to provide mature, stable companies with attractively priced credit backed by assets sitting on their balance sheets, rather than in bankruptcy-remote vehicles (as has often been the case).

In our view, building all-weather credit portfolios requires not only investing up and down the capital structure, but also lending against a variety of collateral, from home mortgages to receivables, that have the potential to offset inflation’s sting and deliver stable, attractive risk-adjusted returns. In addition, as recent bank failures so painfully demonstrated, we believe investors should always mind the fundamentals, including potentially dangerous asset-liability mismatches that can trigger liquidity crunches.

Conclusion

As private-credit markets continue to expand in size, choice and sophistication, we believe that, where suitable, they can play an important role in well-diversified investment portfolios. We believe that skilled underwriting and deep domain expertise remain crucial to delivering attractive risk-adjusted returns in this complex yet potentially rewarding asset class.