SLUGGISH ECONOMIC GROWTH PROSPECTS AND PROLONGED BULL MARKETS IN EQUITY AND FIXED INCOME ARE COOLING INVESTOR SENTIMENT IN DEVELOPED MARKETS TODAY. For investors concentrated in public market securities, these headwinds warrant consideration of other, alternative asset classes to diversify and complement long-only equity and fixed income holdings.1
Private credit—a broad asset class made up of corporate direct lending, real estate debt, consumer lending and many more specialized types of finance (litigation, agriculture, infrastructure and others)—offers potentially attractive solutions for a range of investment objectives, from return enhancement to stable income, while dampening overall portfolio volatility.
The opportunity is available today because of an important structural shift in the market that followed the global financial crisis (GFC). As more onerous regulations were implemented in the banking sector, many financial institutions reduced their lending across market segments. This shift opened the door to other pools of private capital with expertise in these markets. We believe, as we will explain here, that astute investors should explore the variety of offerings available across private credit. Although short-term market fluctuations will affect the nature of these opportunities, private credit is attractive as a long-term investment allocation. The strategic framework outlined in this paper can assist investors in constructing different types of private credit portfolios, depending on their long-term objectives.
DIVERSIFIED AND DIFFERENTIATED RETURN STREAMS
The breadth of private credit sectors off access to differentiated and diversified return streams that can be accretive to the performance of a broader portfolio, whether the objective is to supplement income or growth or both. With variations across strategies, private credit has the potential to provide:
- Greater income: The income typically offers a premium over public securities in a low-yield environment.
- Minimal duration risk: Floating-rate loans offer upside during periods of rising interest rates.
- Lower volatility: Historically, returns demonstrate less volatility than public equities.
- Improved portfolio diversification: Returns have a lower correlation to public and private assets.
- Downside resilience: High-quality counterparties can be sources of long-dated stable income streams.
A brief history: banks’ exit creates an opportunity for private capital
Large financial institutions—such as banks and insurance companies—have traditionally had a large presence in lending across multiple sectors. Leading up to the GFC, the market expanded significantly as new instruments were developed to repackage and transfer risk, which was widely seen as a contributing factor to the financial crisis.
The response to this was a renewed emphasis on banking oversight through increased regulation (e.g., Basel III, Dodd- Frank and CRD-IV2) in an effort to curtail lax lending practices and shore up bank balance sheets. Required to hold more capital against some assets, many banks reduced lending across their businesses, including small and mid-size corporate loans, consumer finance, construction loans, etc. Over time, nonbank institutions have taken a larger role in the marketplace, filling the lending void. This credit market evolution has opened an opportunity for private capital, particularly when backed by lenders with sector expertise.
Opportunities across private credit sectors
In U.S. middle-market lending, for example, the shift from banks to other lenders has been profound, with banks’ share of the market shrinking from 70% to 10% over the past 25 years (EXHIBIT 1). We believe that the continued implementation of new regulations will only further this trend. In Europe, where the banking system is still saddled with an estimated 1 trillion euros of nonperforming loans (NPLs), a similar change is underway, albeit at a slower pace. European regulators were more lenient than their U.S. counterparts in forcing banks to take write-downs and dispose of NPLs. Nonfinancial institutions are gradually entering the secondary market as purchasers of loans. This means that the opportunity set for both corporate and consumer NPLs is still large and can provide access to returns that are generally uncorrelated to other private credit sectors.
U.S. banks’ declining share of corporate lending
EXHIBIT 1: SHARE OF TOTAL MIDDLE MARKET
Source: Wells Fargo, S&P Capital IQ’s LCD; data as of June 30, 2018. For illustrative purposes only.
In a way similar to middle-market corporate lending, a shift toward nonbank private lenders is also occurring in more niche sectors. Lenders with relevant sector expertise can potentially generate attractive yields, but experience managing a business (or operating an asset) in these sectors is important—in the event of a default, the lender may become the owner/operator. One such area is transport leasing, where underlying demand for cargo shipping vessels has grown consistently since 2009. While a major trade-induced economic slowdown would pose a risk, income generation can be protected by targeting long-term leases to high credit quality counterparties with strong balance sheets, and by making loans secured by quality assets. However, industry knowledge and expertise are critical in these operationally intensive segments of the market.
Private infrastructure finance is another specialized area of the market. Its return drivers differ from those of other asset classes, providing investors with an added diversification benefit. Regulated utilities, transportation and contracted power are often underpinned by assets or businesses that generate stable long-term cash flows, making business operations less volatile and more transparent than in uncontracted business models. This is particularly the case when the underlying assets are natural monopolies (e.g., regulated utilities) or have long-term con- tracts in place that provide good visibility into future revenues, which are relatively insensitive to periods of economic weakness. Stable cash flows typically are derived from some combination of monopolistic market positions, stable/transparent regulatory environments, long-term contracts with credible counterparties, mature markets and prudent leverage strategies. Also, each core infrastructure sector has unique risk factors, so that core strategies investing in multiple sectors can reduce volatility.
Real estate-backed lending can also offer a range of opportunities with different risk-return characteristics, from residential or commercial mortgage debt to construction loans and mezzanine debt, to name a few options. Although real estate has typically been associated with a high degree of economic sensitivity, some more esoteric sectors within the credit spectrum are lower risk yet offer attractive yields due to higher barriers to entry, such as non-qualified residential mortgages.
Increased due diligence: understanding risk factors
As is the case for other private assets, private credit investments’ more complex and less transparent nature may bring added risk and require increased due diligence. Understanding a borrower’s financial standing, and the sector in which it operates, are para- mount and can be more challenging in private markets.
Other factors that need to be considered include the structure of the loan agreement: What protective measures—known as covenants—are in place for the consortium of lenders should the borrower default on the loan? Having a like-minded group of lenders at the table can make for a more efficient process in the event of a restructuring. Investors should also consider their overall liquidity budget. What is their ability to allocate to strategies that are less liquid than publicly listed securities?
The growth in available capital has led some lenders to offer a loosening of credit terms—covenant-lite (cov-lite3) and highly levered deals based on generously adjusted EBITDA, for example—particularly among new entrants to the market making concessions to win deals and deploy capital in the market’s more concentrated segments. From less than 10% of new loan issuance a decade ago, cov-lite leveraged loans shot up to about 80% in 2018, as shown in our Guide to Alternatives (EXHIBIT 2). This shift may increase the risk of borrowers defaulting in the event of adverse market conditions, creating opportunities for distressed and special situations investing. While these risks are well known and not new, we would stress that the loosening standards are not uniform across the entire market. This highlights the importance of manager selection, particularly at this stage of the economic cycle.
The majority of nonbank lenders have focused on larger companies frequently connected with financing private equity- sponsored acquisitions. This approach has its advantages: working with sophisticated investors that have access to broader equity pools, if needed; the ability to more efficiently deploy capital into larger deals; and the opportunity to build a relationship with a partner that is expected to consistently be in the market. All these have intensified the competition among lenders. However, the volume of deal flow is greatest in the smaller-size market segment, which is often out of the purview of large private credit funds. This segment may provide more attractive investment opportunities today.
Weaker protections: “Covenant lite” as a percentage of new issuance has grown dramatically
EXHIBIT 2: COVENANT-LITE LOAN ISSUANCE, TRILLIONS USD
Source: J.P. Morgan Asset Management; data as of December 31, 2018.
From Guide to Alternatives 1Q 2019, J.P. Morgan Asset Management, February 2019, jpmorgan.com/gta.
The opportunity today
Since the GFC and banks’ pullback, private credit markets have grown by $500 billion and over 1,000 funds have been raised. In direct lending alone, 71 firms have launched first-time funds. In our view, niche, underserved segments of private credit offer among the most interesting opportunities to capitalize on inefficiencies in the market.
Small to mid-size companies
In traditional corporate lending, relatively attractive opportunities still exist in the lower middle market. Smaller funds are better positioned to source and evaluate these small to mid- size companies where financial covenants still exist and pricing is more attractive.
These often fly under the radar of larger funds, for which the time and resources required to underwrite, structure, originate and monitor these smaller loans outweigh the benefits, given the significant capital they need to deploy.
Less crowded strategies with higher barriers to entry, such as nonqualified residential mortgage origination or the purchase of highly regulated performing loan pools, for example, may be similarly out of scope for many managers that lack the expertise or time to conduct due diligence and fully understand the opportunity and risks. The need to create complex infra- structure or comply with more stringent regulations in order to effectively operate create high barriers to entry. These hurdles help preserve the greater return potential for those able to access these sectors.
Distressed or stressed loans
Those willing to take on the additional risk of this segment can potentially earn higher returns. In a prudent approach to distressed or stressed loans, the manager will identify a catalyst, or event, that could unlock value. Additionally, the manager will determine that the security is materially underpriced relative to its intrinsic value. In these scenarios, it is even more critical that the manager have the expertise to navigate a corporate restructuring. Often, returns are dependent on a bankruptcy proceeding and/or renegotiating and restructuring loan terms with a borrower, making thorough knowledge of the jurisdiction’s bankruptcy laws a must. Also, a thorough understanding of loan agreements, companies, sectors, management teams and/or partners is paramount to achieving successful outcomes.
Private credit investing can access a broad universe of sectors and risk-return objectives
EXHIBIT 3: TYPES OF PRIVATE CREDIT BORROWERS, RISK-RETURN OBJECTIVES
Source: J.P. Morgan Asset Management; as of December 31, 2018.
Building blocks: a broad universe, from core to opportunistic
Although the return potential and size of the opportunities will vary over time, the scope of the private credit market offers many potential strategies ranging from core to opportunistic, diversified across sectors. EXHIBIT 3 outlines some common categories, but given the market’s breadth, these can be segmented further. Investments in each category can be made across the risk-return spectrum.
At one end of the spectrum, private credit can serve as a source of stable income with low return volatility, a complement to a public fixed income allocation. We categorize these strategies as part of the core foundation. We would expect managers taking this approach to own senior, secured performing loans made to high credit quality counterparties with the expectation that returns will be derived mostly from income.
On the other end of our spectrum, the opportunistic category, private credit can be utilized as a source of total return through capital appreciation-based strategies; these are more appropriate to replace or supplement public and/or private equity holdings. We typically see managers that take this approach investing more opportunistically, in distressed, stressed or nonperforming loans. They may be reliant on a particular catalyst to unlock value, with appreciation of the loan’s principal value driving returns. In between is the core complements category, which includes strategies that provide an added level of diversification and/or greater return potential than core foundation, but may be less scalable or more suited for a tactical allocation.
Modeling private credit’s impact on overall portfolio performance
We modeled the addition of different forms of private credit to a portfolio, over multiple market cycles, to provide insight into how an allocation would impact a broader portfolio’s performance. The approach we took was to start with a hypothetical portfolio of financial assets (60% equities, 40% bonds) and to add small increments of private credit. EXHIBIT 4 illustrates how the addition can impact risk-return metrics over the long term. In this simplified approach, we substitute different categories of private credit for listed asset classes that have similar attributes. The output in the table shows the versatility of private credit categories within a portfolio, complementing listed financial assets while also improving the portfolio risk-return metrics. The main trade-off is a reduction in overall portfolio liquidity.
Adding private credit may improve overall portfolio returns and lower volatility over the long term
EXHIBIT 4: IMPACT OF ADDING PRIVATE CREDIT TO A HYPOTHETICAL STOCK-BOND PORTFOLIO
Source: Barclays Capital, Bloomberg, Burgiss, Clarksons, Cliffwater, HFRI, MSCI and J.P. Morgan Asset Management Global Alternatives Research. DISCLAIMER: Past performance is not indicative of future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss. J.P. Morgan seeks to achieve the stated objectives, but there can be no guarantee the objectives will be met. The target returns are for illustrative purposes only and are subject to significant limitations. An investor should not expect to achieve actual returns similar to the target returns shown above. Because of the inherent limitations of the target returns, potential investors should not rely on them when making a decision on whether or not to invest in the strategy. Please see the complete target return disclosure at the conclusion of the paper for more information on the risks and limitation of target returns. For discussion purposes only. (1) Illustrative 20-year analysis using asset class data from 1998 to 2017. (2) The risk-return characteristics are calculated in local currency terms. (3) Volatility is calculated using historical annual 1998–2017 standard deviation of historical returns. (4) Return per unit of risk is calculated by dividing the CAGR by the standard deviation. (5) The max drawdown denotes the maximum historical peak to trough decline in asset values. (6) Equity beta is computed relative to the MSCI World benchmark. (7) VaR@100 is calculated assuming normal distribution and 95% confidence interval.
We first analyze how private credit can complement fixed income. The main objective was to reduce volatility while maintaining or improving the potential for income generation. In the second portfolio, the 10% allocation to global high yield is removed and replaced with two equally weighted components from our core foundation category (we used senior secured corporate debt and global core transport as examples in this analysis, however, these can be replaced with other sectors from the core foundation—see Exhibit 3 for other sectors). This change improves the portfolio’s forward-looking income potential while also reducing the historical max drawdown and equity beta. The substitution illustrates how private credit can play a role as a core allocation, reducing the risk profile of the overall portfolio.
The approach taken in the third portfolio is more applicable for investors looking to private credit as a source of return enhancement. Given that equities are typically the greatest contributor of returns (and risk) in a portfolio of public securities, we substitute our opportunistic private credit category (distressed credit) for 10% of the global equities allocation. This change improves total return on both a forward- looking and historical basis, while also reducing volatility. The results of these two portfolio changes are useful for comparing how different allocations to private credit can impact a portfolio in different ways, depending on an investor’s objective.
It is also beneficial to consider a portfolio of private credit holistically, spanning categories. In the last example, we reduce global equities and global high yield by 5% each and add a 10% allocation to a blended private credit portfolio. This blended private credit portfolio includes components from all three of our categories of private credit (core foundation, core complements and opportunistic) with the goal of improving the portfolio across a variety of metrics. Within this blended private credit portfolio, we overweight the core component (70% to the core foundation) with the remainder allocated to noncore sectors (20% to core complements and 10% to opportunistic). Although we acknowledge that these allocations will vary depending on investors’ objectives, our long-term view has been that investors should place a greater emphasis on core investments within private credit (and alternatives more broadly) as an anchor for their portfolio, while making tactical investments to noncore or opportunistic sectors to improve overall diversification and return potential. This last allocation with the blended private credit portfolio exhibits the highest return/volatility and the lowest max drawdown, equity beta and value-at-risk (VAR) score. Adding the blended portfolio with its differentiated sources of return results in a more optimally diversified portfolio relative to adding any single private credit category. The portfolio improvements come with just a minor allocation to private credit. Although it is not shown in the table, increasing the allocation to private credit would further improve the portfolio output in this model.
Private credit as a long-term strategic allocation
Private credit can give investors access to additional building blocks for constructing well-diversified, strategic portfolios that are more resilient across market cycles. Short-term market fluctuations can be expected to occur late in the cycle, making well-structured and prudent lending at the top of the capital stack particularly important. While default rates currently remain below historical averages, loosening of lending standards may result in lower recovery rates in the event of a market downturn. We believe investors should explore the compelling offerings available across this sector and consider how private credit may better position their portfolios for the long term.