Private Credit: What is it and why should I invest?

Although private credit has been spoken of a lot in the years since the global financial crisis (“GFC”) of 2007-8 (remember that?), it is not a new asset class. Most lending transactions are, in fact, private. Be it your mortgage with a high street bank or the finance you have arranged on your car – these are examples of common private credit transactions. They are “private” simply because they are bilaterally negotiated between borrower and lender and the information about the debt (the size of the borrowing, interest rate, terms and conditions, collateral, etc) is not generally public knowledge – this information is private. Private credit includes investment strategies such as real estate debt, infrastructure debt, distressed corporate debt, direct lending, mezzanine and structured finance.

Private credit transactions can be contrasted to the syndicated loan and bond markets, which are typically large corporate financings that are intermediated by banks and agreed between a corporate borrower and a large number of institutional investors such as pension schemes, insurance companies and family offices. These borrowings, whether short-term floating rate loans or long-term fixed rate bonds, are characterised by having common terms and conditions and by being large issuances. These characteristics make these syndicated loans and bonds relatively easy to buy and sell, so they are often deemed “liquid” assets and considered the debt equivalent of listed (public) equities. The terms of syndicated loan and bond deals are public and the prices at which these instruments trade is also readily available on pricing services and from broker-dealers.

Private lending versus mainstream banking

Private credit was brought into the mainstream during the GFC largely because high street banks stopped lending money and global financial markets ground to a halt as investors lost trust in their trading counterparties and hunkered down to weather the storm.  But credit is a key source of working capital and long-term finance for most companies and their need to borrow and refinance existing debt did not go away overnight. To avoid insolvency and collapse many corporations, both big and small, turned to private lenders to get them through the crisis. Private lenders provided a lifeline to corporations and many continued to partner with private lenders even after mainstream banks returned to lending.  In many respects our economy depended on private lenders to keep going during the darkest months of the GFC.

Why would a company prefer to borrow from a private lender rather than a regular bank? The most common reason is the flexibility of the financing arrangement, the terms of which private lenders are typically happy to tailor to the specific needs of the company. Not only do banks much prefer to lend using a highly repeatable “cookie-cutter” approach that emphasises consistency and volume, but negotiating terms can be a time-consuming and ultimately frustrating process for borrowers as powerless junior bankers run negotiated terms up the flagpole for approvals. It is the inflexible and often inefficient approach to lending by banks that leads many companies to continue to borrow privately long after the need recedes even if their private borrowing costs a little more.

Private credit strategies

Private credit strategies are many and varied but those run by large investment managers are better understood as “platforms”; that is, they are resourced and set-up to provide a range of different financing options, from floating to fixed; asset-backed financings to cash-flow based loans; short-term or long-term. Frequently, investment funds are structured around these capabilities and tailored to the requirements of targeted investor segments. For example, the annuity business of an insurance company may desire low risk and consistent income whereas a sovereign wealth fund or a family office may prefer equity-like returns and be willing to accept the higher risks that such strategies entail. These strategies are at opposite ends of the risk-return spectrum so would be offered as separate funds.

Recently, in response to investor demand to have funds that capture the best investments that a manager sees, “special opportunity” funds have arisen. Such funds are amongst the most flexible in terms of the range of strategies they may pursue and are often positioned at the higher end of the risk-return spectrum. These funds are typically intended to deliver expected returns of 15-20% per annum as a blend of income distributions and capital gains.  These funds make use of the full range of lending capabilities on a manager’s platform, including providing rescue financing to stressed borrowers (those that may be running out of cash) or even those that are currently in distress (having already defaulted on existing debt payments). The latter requires specialist legal and restructuring skills but can provide lucrative returns that are independent of markets movements.

Why invest in a private credit fund?

The most important characteristics of private lending are the key to understanding their potential impact on your investment portfolio. First, private credit investments typically yield or return more than a similar traditional loan or bond. This excess return is often referred to as an “illiquidity premium” because it offers extra compensation for the relative difficulty in selling the investment.

Second, the fact that much private lending is highly negotiated and bespoke to each borrower means that it is inherently very different to the standard form of syndicated loans and bonds in a portfolio of traditional investments. And in investment terms, different is generally good because it implies that the two types of investment will not behave the same, which is the (informal) definition of low correlation and this diversification amongst investments is a highly desirable trait in portfolios. It is the case that private credit strategies have historically exhibited low correlation to bonds and equities.

Concluding thoughts

With global interest rates at or near all-time lows across developed markets traditional fixed income investments currently yield very little. Against this backdrop, the increased return available on private credit investments is more important than ever in helping investors achieve their income and return objectives without necessarily increasing portfolio risk.  It is the potential for private credit to provide increased returns and diversification benefits that motivates considering an investment. The best portfolios are those that consist of a wide variety of investments that have low correlation to each other, resulting in a more resilient and more consistently performing portfolio. And portfolios that deliver more consistent performance are less likely to elicit either panic selling or desperate buying, resulting in a better long-term investment performance.

References

1. Amin, Rajan Prof. (September 2015). The Rise of Private Debt as an Institutional Asset Class. ICG, Preqin.
2. Mistry, Sanjay & Ripka, Tobias (26 February 2018). Private Debt in an Institutional Portfolio. CAIA Association
3. Alternative Credit Council, AIMA (2019). Financing the Economy: The Future of Private Credit.
4. Alternative Credit Council, AIMA. Private credit explained. https://acc.aima.org/resources/about-private-credit.html
5. Cambridge Associates (2017). Private Credit Strategies: An Introduction.
6. Pitchbook Blog (5 February 2020). What is private debt?
7. IQEQ Insights (29 July 2020). The rise of private credit: who, what, where and why. https://iqeq.com/insights/rise-private-credit-who-what-where-and-why
8. IQEQ Insights (12 August 2020). The merits of private debt in these troubled times. https://iqeq.com/insights/merits-private-debt-these-troubled-times
9. Funds Europe (4 June 2020). How will private credit after the crisis. https://www.funds-europe.com/news/how-will-private-credit-perform-after-the-crisis

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