Despite warnings of its imminent demise the asset class is here to stay
- The recent growth of private credit does not constitute a bubble
- Private credit should do well when the economic cycle turns
- Distressed/secondary credit is a sub-strategy that can generate equity-like returns
- The asset class can provide another tool to deliver cash yield and shorter duration, while generating attractive risk-adjusted returns on an absolute and relative basis
Much has been written about the rapid growth of the private credit asset class and the potential of a ‘bubble’ forming. Our view is that we are experiencing the growth and natural evolution of a nascent asset class – that experienced by private equity during the early-to-middle 2000s.
This growth is healthy. It provides limited partners (LPs) with previously unavailable choices, while addressing the investor need of attractive risk-adjusted returns, cash yield and shorter duration in the alternatives space. Importantly, a portion of the growth has been driven by the once-in-a-lifetime phenomenon of bank retrenchment. This is particularly relevant to middle market corporate lending. As a result, a void of debt capital has been created, which privately-focused lending groups have filled.
But what about the cycle ending? It is difficult to know exactly when the next downturn is coming or what it will look like. Are we closer to the end of the cycle than the beginning? Probably. Will there be an economic recession soon? Absolutely. However, predicting this with any precision is difficult. Rates have already risen (despite the ‘pause’ by the US Federal Reserve), global GDP growth has begun to slow and valuations will inevitably come down.
However, our data suggests that heading into and coming out of an economic cycle is when private credit shines. Importantly, 86% of the asset class is floating rate, meaning in a rising-rate environment, existing investments benefit from a higher cash coupon. Let us not forget a key reason for leaning into this asset class in the first place – the risk profile.
Investing in this asset is not just about an absolute level of return; risk needs to factor in as well. By investing in the more senior parts of the capital stack and with attractive underlying attachment points and loan structures; downside protection and risk mitigation are heightened, becoming key components of generating outperformance relative to other investment strategies during a downturn.
Is there a downside?
Let us take this one step further. Many of us — particularly downside-focused credit investors — are cynics. So, let us think about it from the perspective of ‘How bad can it get?’ We measured the worst rolling five-year performance by asset class over the past 20-plus years and across more than 400 private credit funds. How does private credit compare? Not too shabby. The results show that the strategy stacks up well on an absolute and relative basis even in this most draconian of performance views (see figure).
And, compared with other ‘yield’ oriented benchmarks and asset classes, which also benefit from rising rates, private credit has the benefits of tighter structures, better lender information and more downside protections than in the more efficient public debt markets.
This makes sense. For those invested in more senior parts of the capital structure and who have relatively stronger protections/loan documentation, these private debt securities should protect value more effectively than in junior parts of the capital structure or equity-oriented investment positions.
For the same reason, when an recovery occurs, value in credit securities snaps back faster.
Distress brings opportunities
Also, let us not forget about another segment of private credit: distressed and secondary debt strategies. Generally, these have received less publicity than performing or origination-oriented strategies and growth in assets under management, but distressed/secondary credit is a sub-strategy that can generate equity-like returns heading through a cycle. Investors have recognised this a counter-cyclical lever within the credit space.
The punchline is simple: private credit is here to stay. From the perspective of an investor there are also several factors driving increasing allocations into private debt. Private credit brings something different in terms of expected investment duration (shorter) and J-curve profile (better) compared with the experience those investors gain from a private equity exposure. There is more consistency both in terms of cash yield and overall return performance with credit. Volatility is lower.
For example, and again looking at asset class data from the past 20-plus years, the spread on the internal rate of return between top-and-bottom quartile credit fund managers is roughly 500bps narrower than the same measure of volatility an investor would experience in equity buyout oriented strategies. Similarly, private credit returns also have a lower probability of negative returns, when compared with buyout.
From a borrower/company perspective a key question is: why utilise private credit when, particularly of late, the public debt markets have been so accommodating? There are many factors influencing the answer. Even if the cost of debt may be lower via a public debt market, the borrowers (which are often the private equity owners of these issuers) value flexibility and the ability of private capital to provide a bespoke financing solution, particularly if a transaction involves a complex capital structure or set of deal dynamics.
Similarly, there is an element of control for the borrower. By utilising private debt financing, a company can select one or a handful of lending partners compared with having no control in a public debt syndication. There are also different information sharing considerations. Lastly, it is not always about the lowest cost of capital or ‘loosest’ debt structure for a borrower. For example, a company seeking to acquire another business may value having a private debt structure over a dependency on potentially fickle public debt syndication processes or financing contingency.
Private credit will continue to prove its worth over time. As an investment strategy, it can provide investors with another tool to deliver cash yield and shorter duration, while generating attractive risk-adjusted returns on both an absolute and relative basis. Many investors will continue to lean in to private credit and develop focused strategies in the asset class. This makes sense. No need to head to the underground bunker just yet.
Drew Schardt is global head of credit investments at Hamilton Lane