Private credit is an attractive asset class for investors.
Private credit has emerged as a popular alternative asset class for investors seeking to diversify their portfolios and generate attractive risk-adjusted returns. This article from GSFM’s examines this asset class and outlines the investment case for private credit.
Inflationary pressures and economic uncertainty have increased, creating volatility across financial markets as Central Banks have increased policy rates. This is exacerbated by a tight labour market, rising energy costs, ongoing supply chain disruptions, geopolitical events, as well as a hangover from 10 years of loose monetary policy.
A breakdown of the usual relationships between asset classes, notably equities and fixed income, has seen many advisers seek alternative investments to diversify the risk in their clients’ portfolios and generate returns at a time when traditional assets are underperforming.
Private credit is one of these alternatives, an asset class that can diversify investment portfolios and generate attractive risk-adjusted returns. Private credit refers to the lending of capital by non-bank financial institutions to companies that are not publicly traded. Unlike traditional bank lending, private credit offers investors the opportunity to invest directly in the debt of privately held companies, with the potential for higher yields and less volatility than public markets.
In recent years, private credit has gained significant traction as an asset class, with institutional investors increasingly allocating capital to private credit funds. Globally, the private credit market has expanded significantly, with assets under management in excess of US$1 trillion and set to grow further as banks continue to pull back. At the same time, relative under-penetration of private credit in Australia represents a significant growth runway.
In this article, we explore the benefits and risks of investing in private credit and outline the reasons you should consider including an allocation to private credit in your clients’ portfolios.
What is private credit?
Private credit or private debt – terms that are used interchangeably − is an asset class of privately negotiated loans and debt financing from non-bank lenders. It is an alternative form of finance for privately held companies in the form of loans, bonds, notes, private securitisation issues or asset backed financing – in effect, any non-listed debt product. It covers a wide range of risk profiles, from the largest investment grade blue chip corporates all the way to small startup venture capital types of businesses.
Borrowers seek private credit for various reasons, including:
- an inability to access public credit markets
- cannot access traditional bank financing
- bank financing is too restrictive
- do not want to be diluted by issuing new equity
- require funds quickly.
Private credit mostly involves non-bank institutions such as specialised credit managers, insurance and asset managers, superannuation funds and Family Offices making loans to private companies or buying those loans on the secondary market[1].
Key features of private credit include:
- more flexible terms and conditions for borrowers compared to traditional bank financing
- executing a private credit financing is quicker than a public credit market or bank financing transaction
- often floating interest rates versus fixed interest rates for bond markets
- traditionally was not available to the general public, but this is changing.
Why invest in private credit?
Investing in a private credit fund can offer several potential benefits to investors, including:
- Potential for attractive returns: private credit funds can potentially offer higher returns than traditional fixed-income investments because private credit funds invest in non-publicly traded debt instruments, such as private loans or structured credit, which can offer higher yields.
- Diversification: private credit funds can provide diversification benefits to an investor’s portfolio. By investing in private credit funds, investors can gain exposure to a range of different debt instruments and borrowers, which can help to spread their risk and potentially improve the overall performance of your clients’ portfolios.
- Lower volatility: private credit funds can offer lower volatility amid geopolitical uncertainties, inflationary pressures and historically high asset valuations compared to more traditional, public, investment products.
- Access to institutional-quality investments: historically, private credit funds are typically only available to institutional investors or high net worth individuals. By investing in a private credit fund, individual investors can gain access to institutional-quality investments that may not be available to them otherwise.
- Potential for downside protection: Private credit funds often have tighter covenants in place that provide downside protection that reduce the risk of capital loss and help to ensure that appropriate returns are maintained relative to any changes in credit risk.
Most notable of the protections is the security position held by lenders, which provides priority in the payout order relative to equity or other unsecured creditors This significantly reduces the risk of capital loss for debt investors, with any losses being borne first by equity holders.
When structuring new loans, private credit managers typically carefully consider the debt/equity ratio in this context to ensure an appropriate equity buffer exists. In addition to security, loan documents typically include a range of other protections, including financial maintenance covenants, as well as a range of restrictions placed on borrowers aimed at minimising cash leakage.
Financial covenants are typically tested quarterly and can provide lenders with an early warning sign of stress, and an opportunity to engage with the borrower to assess whether changes to the loan structure are required to ensure protection of the lender’s capital position, and that returns remain appropriate relative to risk.
Overall, investing in a private credit fund can provide investors with the potential for stable, regular cash income with superior downside protection. The floating rate profile provides capital stability versus traditional fixed income investments and is a hedge against an inflationary / rising interest rate environment and duration risk.
However, as with all investments, private credit funds also carry risks. Advisers should carefully consider each client’s investment objectives, risk tolerance and other factors before including an allocation to private credit in an investor portfolio.
Private credit and the current environment
As interest rates in Australia rise from historical lows to more normalised levels, total returns from private credit appear increasingly attractive relative to long-run average returns from other major asset classes.
While equities and fixed income may, at times, present opportunities to generate above average returns, it may be challenging to achieve above-average results over the long-term, particularly within a diversified portfolio. In contrast, private credit offers reduced volatility and consistent cash returns.
The recent sharp increase in inflation has led central banks globally to aggressively raise interest rates, and this is expected to continue in the near term. These significant interest rate and yield curve movements have led to increased volatility and downward price pressures in equity and fixed income bond markets.
In this environment private credit presents an attractive investment proposition relative to other asset classes, with favourable risk-adjusted returns, a floating rate profile and strong downside protections for Investors. However, it is important to acknowledge that with increased economic turbulence can come additional risk, making manager selection crucial to achieving through the cycle success.
How does private credit differ from fixed income investments?
Traditional fixed income assets are exposed to market losses as a result of duration risk. As rates rise, the relative value of future fixed coupon payments declines vs. prevailing market rates, negatively impacting the price of the bond and resulting in mark-to-market losses and potential capital loss if sold before maturity. A floating rate private credit product mitigates duration risk and associated mark-to-market volatility, while providing investors with a growing income stream as base rates rise.
Credit investors in senior private credit markets often benefit from a first ranking security position. Unlike bond markets however, investors in private credit are typically able to derive additional protections through structuring of financial covenants which address the specific risks of a particular transaction and provide an early warning signal allowing lenders to take action to protect their position.
This is especially true for private credit managers that focus on mid-market lending transactions that benefit from stronger financial covenant protections compared to larger syndicated deals. In an uncertain economic environment, this additional protection can prove critical.
Things to be aware of when investing in private credit
Investing in private credit also comes with certain risks that investors need to be aware of. Private credit investments are illiquid and may be subject to credit risk, interest rate risk and liquidity risk. Therefore, it is important that you consider each client’s risk tolerance, investment objectives, as well as the track record of the private credit manager before including private credit in a client’s portfolio.
While higher interest rates may enhance investor returns, they can also make it more difficult for a borrower to service their debt. This can become problematic for lenders who have not considered this scenario in their analysis and have provided debt at a level that is too high.
Additionally, current economic uncertainty presents both supply and demand side risks for businesses that may have an adverse impact on earnings, potentially reducing both debt serviceability and business valuations.
Ideally, the investment approach adopted by the private credit manager will be characterised by detailed cash flow and sensitivity analysis to assess a business’s capacity to service debt under a range of different economic and downside scenarios.
When markets are bullish, leverage multiples tend to rise, and terms and conditions are relaxed. When the tide turns it is these transactions that will come under pressure first. Thus, discipline through the cycle is crucial to ensure stability of returns.
Important in allocating capital to private credit is the manager’s track record through cycles, as well as their network and ability to originate loans directly. This puts the manager in a position to dictate terms or walk away when investor protections are being diluted. Scale is also important as it provides capacity to extend meaningful loan sizes to borrowers. It also provides investors with diversification in the portfolio, so they do not find themselves overexposed to just a small number of names and sectors.
Why include private credit in client portfolios?
The continued growth of the Australian and regional private credit market, the floating rate and structural protections inherent in private credit products, and the consistent low volatility cash returns presents an exciting opportunity for investors.
In light of the difficulties in 2022 and the challenges that lie ahead in 2023, many investors are revisiting their approach to investing as traditional strategies (including the 60/40 portfolio) have performed poorly during the recent market volatility.
An allocation to Australian private credit can provide a ballast for investors’ portfolios. It offers stable cash income with an attractive risk-return profile, strong investor protections, low correlation with public and global private markets while the floating return profile provides a natural hedge against inflation / interest rate movements. The asset class also has a long growth runway given its relative under-penetration against more mature, offshore markets.
In spite of the headwinds facing the global economy in 2023, Australia’s economic outlook remains relatively positive. It benefits from a diverse economy with a growing technology and services sector, complemented by abundant resources and energy. Australia’s economy is projected to grow 2.5% in 2023, well above the developed economy average of 0.9% and 1.0% for the US. Immigration will increase to support the labour sector and bring further investment.
The outlook for Australian private credit looks constructive, albeit in an environment of economic uncertainty and higher interest rates reducing debt serviceability for borrowers over the course of 2023. In such an environment, and against a more volatile global credit market backdrop, conditions will continue to swing in favour of lenders who will be able to demand higher returns, lower leverage and tighter terms and conditions.
In such an environment, it is critical that advisers entrust their clients’ capital with an experienced manager with a strong track-record over several credit cycles to effectively navigate the risks and uncertainties ahead in 2023, while also maximising the downside protection features offered by private credit. Importantly, private credit represents an attractive opportunity for investors to diversify into an effective and defensive investment strategy as they face an unusually uncertain 2023.
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