Manager skill in underwriting credit risk and executing transactions will likely become more valuable as higher rates increase borrower stress.
New asset classes don’t come around very often, but their arrival can open up the opportunity set for investors in useful ways. Over the past decade or so, private credit has emerged as a distinct stand-alone component of diversified portfolios, taking a place alongside long-established alternative investment categories such as private equity and hedge funds. By focusing on lending into sectors previously dominated by banks or public capital markets and combining modest leverage and closed-end fund structures to increase potential returns and manage asset-liability risks, private credit has delivered a compelling mix of high returns and low realized volatility.
Investors are responding. Capital is flowing into private credit strategies at a rapid pace, and assets under management now approach USD 2 trillion (Exhibit 1). Today, allocators can access a maturing market with large populations of managers across numerous subsectors, allowing them to tailor exposures to reflect specific opportunities across the credit markets.
While the enthusiasm for the new asset class is understandable, we see some potential challenges on the horizon. Private credit has “grown up” in a period of low interest rates, inexpensive leverage and limited defaults but must now adapt to an environment of high rates, costly leverage and rising credit risk. Today’s high yields present an opportunity for lenders but also pose a direct risk to the solvency of borrowers. That, in essence, is the paradox of private credit. In this paper, we assess the risk-reward calculus across the subcomponents of the private credit opportunity set and suggest some ideas for optimizing allocations in the current environment.
A hybrid asset class
Although broadly classified as an alternative investment, private credit should be thought of as a hybrid asset class that occupies a middle ground between riskier equity and lower risk fixed income. In comparison with other illiquid alternatives, it is more conservative than private equity or venture capital, as befits a sector based on lending rather than equity ownership. As a fixed income strategy, however, private credit occupies the riskier end of the spectrum, adjacent to sectors such as high yield, leveraged loans and distressed debt.
Investors should consider these different themes when evaluating the role of private credit in portfolios.
- The rapid growth and segmentation of the private credit universe do not necessarily lead to a corresponding diversification of key macroeconomic risks; most forms of private credit will directionally increase the sensitivity of a broader asset allocation to credit cycles. It will be helpful to build structural diversification into private credit portfolios sooner rather than later.
- Today’s growing allocations need to be put to work, and there is a real risk that credit underwriting standards may decline just as higher interest rates increase borrower stress. Managers with experience across past default cycles and the discipline to maintain underwriting standards will be essential.
- Private credit’s historical performance shines within the mean-variance optimization models that drive much of the asset allocation process today. Allocators should look closely at the various components of private credit returns and consider how a changing environment may impact them going forward.
A capital surge across subsectors and styles
Market participants commonly cite a basic rationale for the emergence of private credit: It solves a classic problem of the traditional banking system, which is the asset-liability mismatch created by funding long-term loans with short-term demand deposits. In contrast, using long-term investor capital within closed-end fund vehicles ensures that private credit funds can keep capital invested without being subject to a “run on the bank.” Recent struggles within the U.S. banking system from deposit flight, high funding costs and losses on legacy asset portfolios further constrain the ability of traditional lenders to provide credit. As a result, private lenders find greater opportunities to step into the shoes of tapped-out bankers (Exhibit 2).
As more capital has arrived, the private credit ecosystem has evolved and expanded – creating new momentum for the asset class in investor portfolios. Allocators are diversifying across subsectors and styles, seeking skilled managers who can generate strong risk-adjusted returns (Exhibit 3). While direct lending remains the dominant subsector, other specialized areas, like mezzanine debt, venture debt, special situations, distressed credit and secondaries, are growing rapidly as well.
The ability to deploy capital across a wide range of subsectors and managers is a good thing, of course. But investors should be careful about conflating the complexity of the private credit market with genuine diversity of risk – particularly with respect to macroeconomic risks from business cycles and monetary policy.
Ultimately, most of the underlying borrowers are subject to broadly similar economic conditions and levels of interest rates. Should an economic downturn occur, default risk will inevitably rise. If this downturn takes place while the Federal Reserve (Fed) is still fighting inflation and interest rates are elevated, the level of borrower stress will increase significantly – an eventuality that has not been experienced over the relatively brief history of this asset class.
Investors need to consider the ways in which these risks will correlate with other exposures in their portfolios, most notably in the public equity and credit markets. A practical response will be to direct portions of the private credit allocation to subsectors that are structurally defensive on the one hand and opportunistically positioned to benefit from volatility on the other.
Higher yields, higher levels of borrower stress
Extremely attractive all-in yields available in the loan market are fueling the current enthusiasm for private credit. But what will be the impact of these elevated rates on borrowers who have few other sources of capital? After all, an investor’s interest income is simply the flip side of a borrower’s debt service cost. Punishingly high interest rates will inevitably lead to higher levels of stress among borrowers.
Already, we see rising default rates in the high yield and loan markets (Exhibit 4). Private lenders typically have more tools to help avoid outright default, but such flexibility has a cost to investors. They may accept new payment-in-kind (PIK) debt in lieu of interest, but this is a stopgap measure that makes it harder to distribute returns to investors. Extending principal maturities – another common device – has the same effect. Investors will come to realize that low default rates are cold comfort if they are getting paid with new debt and on a delayed schedule.
Components of private credit returns: Positive and negative factors
To evaluate private credit relative to other asset classes across the capital markets, simple extrapolation of historical performance may prove to be misleading. Instead, we look to decompose private credit returns into several key components, including: a base interest rate, a credit spread component, the return-enhancing impact of leverage, the cost of that leverage, and losses from defaults in the portfolio. Given the pivot from a benign historical credit environment to a more challenging present (and likely future) credit environment, it is helpful to think through each return component, how it has changed recently and how it will contribute to returns going forward (Exhibit 5).
Clearly, as we have noted, private credit is operating in a materially different market environment today vs. the post-GFC era. In place of low base rates, inexpensive leverage and limited defaults, we now observe high base rates, costly leverage and rising defaults. Time will tell how much returns are impacted going forward, but investors should consider what they are getting in return for their capital commitment.
Higher potential returns that result purely from the increase in base rates do not represent a unique value proposition for private credit – all fixed income sectors have repriced to the higher rate environment. Paying private fees for this portion of the return stream is inefficient.
Credit spreads may offer more value: In most sectors of the private market, spreads remain materially wider than in the riskier sectors of the public markets. While some of this premium is a necessary compensation for illiquidity, it also provides a compelling value when combined with the quality and diversification available within the private credit opportunity set.
Manager skill in underwriting credit risk and executing transactions will likely become more valuable as higher rates increase borrower stress and a potential turn in the credit cycle leads to rising default risk.
To date, many direct lenders have benefitted from the “beta trade” of a benign credit market; going forward skill will play a greater role. Deep knowledge in specific sectors, a long track record of lending through credit downturns, and expertise in handling workouts and restructurings, will differentiate managers to a greater degree than in the post-GFC era. We also expect to see greater differentiation between lenders who have focused on financial sponsor (private equity) backed borrowers, and those who are lending to independent firms.
Structurally defensive and selectively opportunistic
Of course, hiring skilled managers to originate new private loans will continue to be a key driver of success in private credit investing. But asset allocators can also take advantage of specific subsectors of the private credit markets that are well positioned to deliver strong performance during a period of elevated credit risk. We highlight both more defensive and more opportunistic strategies that may be helpful here.
Real estate mezzanine debt
From a more defensive perspective, core real estate mezzanine (RE Mezz) debt strategies offer several valuable attributes that may help shield investors from a broader credit downturn. These include a high quality of assets and sponsors (borrowers), structural downside protection, strong covenant protections, and limited fund-level leverage. It’s not a coincidence that RE Mezz debt exhibits lower risk characteristics today: During the global financial crisis, real estate mezzanine debt suffered from a high degree of structural leverage and complex capital structures that proved to be vulnerable to volatility in the underlying assets.
Today’s real estate mezzanine debt market operates with simpler capital structures that include a higher level of equity cushion to absorb downside risk and a level of senior debt that provides a lower attachment point and a more secure position for the mezzanine (Exhibit 6). The underlying assets, while not without risk, offer a suitable level of financial and operational transparency to allow rigorous underwriting, and the breadth of the underlying core real estate market allows for the construction of diversified portfolios. Further, mezzanine lenders’ critical role in establishing a viable capital structure allows them to dictate favorable terms while also maintaining an indirect security interest in the underlying asset that offers significant advantages in the event of distress.
Distressed and special situations
At the higher end of the return and risk spectrum, investors can find distressed credit and special situations funds positioned to benefit directly from credit stress – particularly in the case of borrowers who have exhausted other sources of financing. There is a wide range of investment styles in this sector. But they often involve managers purchasing legacy claims from former lenders at a significant discount and/or refinancing existing debt on more favorable terms that include additional security and exposure to the upside in the event of a recovery. Many of these funds can offer high interest secured loans while also receiving some form of equity compensation – quite literally bridging the gap between debt and equity (Exhibit 7). There may well be a lag between higher rates and the onset of credit stress, but making commitments to managers now will pay off as opportunities emerge.
While highly individualized, distressed and special situations strategies generally look to acquire assets at a deeply discounted price that offers both downside protection and a realistic prospect for price appreciation in the event of recovery. This places greater importance on a manager’s structuring skill, as well as experience in sourcing transactions involving substantial complexity, which prevents traditional lenders from getting involved. Income plays a role in driving returns, but as the level of borrower distress increases, it is supplanted by deals that are structured to maximize exposure to a recovery, often following some sort of workout and involving a hands-on management role.
Private credit secondaries
Finally, investors should bear in mind that a rapidly growing market for primary investments in illiquid closed-end funds will eventually generate calls for interim liquidity from investors. Managers who are able to provide a secondary market for limited partnership (LP) stakes in private credit funds will earn outsize returns by purchasing them at a discount to their stated net asset value (NAV). Over time, managers dedicated to the secondary space will facilitate the reshuffling of risk among investors while also allowing those looking to place capital in the market quickly and to acquire seasoned portfolios efficiently. We discussed this subject at length in an earlier paper.
Private credit secondaries derive their return from three basic sources (Exhibit 8). The first source, the majority of the return, is the natural yield on the underlying investment portfolio, enhanced by the fact that assets were purchased at a discount to NAV. The second most meaningful share of the return is the capacity of the of the underlying assets to mature at levels above the purchase price (the “pull to par”). The third and smallest contributor is principal accretion, which is the result of securities in the underlying portfolio paying-in-kind or offering other equity stakes or warrants.
A prudent approach to optimizing allocations
The strategic benefits of private credit are compelling. Investors are able to supply credit to sectors of the credit market that used to be serviced by banks, but within a fund structure that is simultaneously better suited to managing risks and delivering strong risk-adjusted returns. A core/satellite approach, focused on direct lending strategies alongside a more diverse set of sector strategies, has become commonplace. Within this framework, finding managers with long track records of successfully underwriting credit risk will be become even more essential.
But additional changes may be needed, as the strong returns and low risk that characterized the initial stages of private credit’s development may prove difficult to sustain. The current surge of investment may challenge the capability of managers to allocate capital effectively, while a potential turn in the credit cycle may raise the risk of borrower stress. The defensive benefits of mezzanine debt and the opportunistic benefits of special situations and secondaries should take on more significant roles. A prudent approach to private credit will manage both risks and opportunities across the investing spectrum.