Private credit: An all-weather asset class

The market for private credit is growing rapidly and is attractive for investors even in tough economic times. Although conventional interest-bearing instruments by now have resumed delivering higher yields, private credit is alluring investors not just with an additional yield premium, but also with robust defensive attributes at the same time. But whoever would like to profit from the benefits of this asset class has to be willing to sacrifice liquidity in return.

 

A growing niche

The private credit, or direct lending, market has been registering rapid growth for years now. Private credit mutual funds managed only a total of around USD 100 billion in 2007, but the size of this asset class has exploded more than tenfold since then, and not by chance. Ever since the Great Financial Crisis, tightened capital adequacy requirements and stricter regulation have prompted banks, as traditional lenders, to increasingly pull out of certain areas of the lending business, thus opening space for new competitors like specialized private credit funds, for instance. The trend appears to be unstoppable and is bound to be fueled further by the latest banking crisis in the USA sparked by the collapse of Silicon Valley Bank. Banks will further restrict their lending in the future, and non-banks will gladly step in to fill the resulting voids. The private equity industry’s increasing demand for borrowed capital will also likely continue to bolster growth in private credit.

 

Banks are pulling out,… | …opening space for private credit

Market share in loan financing for midsized US private equity deals

Sources: McKinsey, Kaiser Partner Privatbank

 

Attractive yield premium…

Despite the vibrant growth, private credit until recently remained a small niche in the universe of private-market assets. Lately, though, the private credit segment is beginning to interest a somewhat broader swath of the investing public. Although the phase of ultralow and negative interest rates is over now and even classic interest-bearing investment instruments have resumed assuring solid yields, private credit nonetheless continues to lure investors with an attractive yield premium versus conventional corporate bonds. In US dollar terms, this yield pickup currently amounts to 6 to 7 percentage points above investment-grade bonds and 3 to 4 percentage points above high-yield bonds. But the expected yields aren’t just higher, they are also much less volatile. This is because private-market loans carry variable interest rates and their coupons usually reset based on a pre-agreed reference rate every three months, which minimizes interest-rate risk. This adjustment mechanism provides effective protection against inflation at the same time because when central banks raise policy rates in reaction to elevated inflation, yield levels on private-market loans thus rise as well automatically.

 

Premium to be earned | Well secured and less volatile

Yields on different interest-bearing asset classes

Sources: Bloomberg, Kaiser Partner Privatbank

 

…with good downside protection

Conversely – in the event of falling interest rates – this automatism is limited, however. Loan agreements typically stipulate a floor that guarantees a minimum coupon. Private credit offers defensive attributes that go beyond this. Private-market loans are usually senior loans positioned at the top of the capital structure that are serviced ahead of other creditors’ claims. Moreover, in contrast to high-yield and investment-grade bonds, private loan agreements often contain covenants obligating the borrower to not breach certain financial-ratio levels. Compliance with covenants is usually reviewed on a quarterly basis. Covenants protect the creditor by imposing limits on the borrower, such as a maximum leverage ratio, a minimum EBITDA, or a minimum fixed-cost coverage ratio. Such covenants help to detect signs of financial stress early on and to address them before they turn into more serious problems. Last but not least, private credit borrowers are often owned by one or multiple private equity firms, which work very closely with the management of the company and frequently provide an additional capital injection in financially strained times. In the past, all of these attributes have resulted in very low loan default rates, high recovery rates, and low loss rates in private credit products. The private credit asset class has consistently exhibited a robust performance in the past even in turbulent economic periods and tempestuous market phases. Even during the Great Financial Crisis of 2008–2009 and the coronavirus crash of 2020, share-price drawdowns in the private credit fund space remained confined to single-digit-percent territory. Over the long run, private credit promises stock-like returns, but with only around a quarter of the volatility.

 

A particularly fine vintage year

Private credit looks particularly promising at the moment – the 2023 vintage year even looks set to become the best one in a long time. Why? Because, on the one hand, reference indices have risen sharply on the back of massive interest-rate hikes by central banks (to more than 3% in the Eurozone and almost 5% in the USA). Moreover, the adverse capital-market climate and the broad abstinence from competition on the part of banks has further improved credit conditions from the perspective of lenders and thus ultimately for investors in private credit. Private credit funds now are not only able to demand higher risk premiums and fees, but at the same time can often also demand better collateralization. Despite the increased costs, however, private credit remains interesting for borrowers. This is because private credit transactions generally transpire much more quickly than traditional bank loan agreements do, and besides giving borrowers peace of mind that a deal actually will come to pass in the end, private lenders are frequently very flexible in custom-structuring loan conditions.

 

2 in 1 | A rain umbrella and parasol at once

Private credit return decomposition using the USA as an example

Sources: Blackstone, Kaiser Partner Privatbank

 

Nothing is for free

Naturally, the many benefits of private credit – like so many other things on the financial markets – don’t come for free. Besides the (product) costs to take into consideration in the private credit space, which are indeed higher compared to conventional interest-bearing assets, the not-for-free caveat particularly applies to liquidity. Typical private credit funds lock in capital for several years and invest it only gradually, which hampers the practicability for the average investor. Evergreen funds try to counter this problem. Most of them offer the possibility of monthly subscriptions and monthly (or quarterly) redemptions for fund shares, making this inherently illiquid asset class at least semi-liquid this way. Investors who find even these terms too inflexible should remember that even the purported liquidity of conventional interest-bearing securities like investment-grade corporate bonds and junk bonds can dry up in times of crisis, potentially rendering them only tradable below their fair value. Moreover, the yields stamped on the label of these traditional instruments are only guaranteed if the securities are held to maturity – along the way there they are subject to large fluctuations. Private credit, in contrast, gives investors a less spectacular yield stream from month to month, but one that, in exchange, is all the more consistent.

 

Oliver Hackel, CFA Senior Investment Strategist

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