Please note: The statements and opinion in this blog are intended to foster the exchange of individual investment experiences. All statements are the private views of the individuals who have written the respective article and are in no way related to any activities of any company. As always investing involves risks. for Professional Investors only. Please refer to our disclaimers below.
The asset class ‘Private Credit’ is booming. In 2007 private credit markets held just $280 billion of assets under management. As of 2022 that value reached $1.5 trillion (expected to reach $2.7 trillion by 2028) — explosive growth! Companies want and need accessible debt financing and they have turned away from banks and towards private lenders to get it. Of course, such growth and the continuing returns for such specialised institutional lenders draw more capital inflows into the sector. Simply put, bypassing traditional bank lending offers benefits for both sides: higher yields and more protection for investors and better access and flexible terms for borrowers.
In our opinion the asset class is still well-positioned for attractive opportunities, even after years of high capital demand in view of banks’ reducing lending supply.
But will private credit markets continue to perform under recently changed conditions? We now operate within a lower GDP, higher inflationary, higher rate landscape and the asset class has seen enormous amounts of capital inflows. We investigate the private lending sector and determine if there are opportunities to exploit.
The Shift from Public Markets towards Private (Credit) Markets
First, what drove such rapid growth in private credit? We identify several underlying trends on both the supply side and demand side for private debt:
- Banks are (forced to be) more risk-averse: After the crisis of 2008, banks were forced to scale back on their own risk exposure. Increased regulation limited the reach and strength of traditional lenders. Lending became expensive for banks due to increased regulatory capital requirements so availability of credit from banks was suddenly reduced.
- Corporates remain hungry for expansion: At the same time, corporates were not retrenching at all. During the period, M&A quickly picked up again and deal-flow as well as further global expansion and other economic growth drivers led to sustained demand for borrowing facilities on the corporate side.
- Lenders grew ever more sophisticated: Institutional lenders with deep pockets built up very large and diverse teams of credit analysts with deep sector and structuring expertise. In the institutional lending world, know-how creates an advantage, because the better one can understand a particular credit risk, the better (i.e. lower) it can be priced. That makes for attractive offerings just at the right time, when borrowers needed funding as their banks kept turning them away.
- Borrowers desire more customization: For many corporates, private lenders can offer better solutions in terms of execution certainty, funding timelines, facility size and maturity. That allows organizations with unique requirements to act more nimble within their markets, pursue expansion opportunities or optimize their capital stack.
- Pension and sovereign funds provide funding: After 2008, just as pension funds were looking for “safer” havens on the back of their badly impacted public equity portfolios and sourcing investments that yield more than their low-interest bond portfolios, private lending emerged as an asset class that appeared to fill exactly that gap. Higher yields but safer than equity. As a consequence, institutional investors continuously increased allocations to alternative investments. Private credit now makes up a large share of the private markets. Between 2007 and 2017, inflows into credit funds rose 9% p.a. , while Private Equity funds inflows increased 7% p.a.
- And finally, attractive returns:1
Private credit returns rise with interest base rates and currently remain ahead of private equity returns. Even better, those excess returns are not earned by taking additional risk but by utilising favourable market conditions, which are currently working in lenders’ favour (e.g. leverage levels).
Many private credit strategies earn risk-adjusted returns well above 10% per annum. 2 In fact, in our own portfolio we observe gross returns of between 10% − 16% per annum,3 depending on the strategy and sub-asset class we have invested in.
The Golden Moment of the Private Credit Sector
These historical trends help explain why private credit is currently having its “Golden Moment”:
- Private lenders financed an all-time high 59% of leveraged buyout transactions last year.
- By 2028, the global private credit market projects to reach $2.8 trillion, with annual growth rates of 10.9% in the US and 13.6% in the EU.
- Direct lending dominates private credit markets, making up 45% of its AUM in 2022.
- The asset class is in our view able to generate attractive risk-adjusted direct lending yields.
Considerations for the Future
- Normalization: Markets are catching up to the rapid effects of central banks changing monetary policy. There could be some total return compression due to lower base rates and potentially lower credit spreads in the future. However, the recent “higher for longer” theme in the market, referring to higher interest rates for a longer period of time, could easily become a “high as the new normal” — benefiting the asset class due to their floating rate character.
- Possible uncertainties: We anticipate that there will be increased market and public-to-private transactions. That may lead to more volatility. The same goes for continuing geopolitical risks and abrupt changes in investor confidence. Downturns in trade relations and issues with supply chains (as painfully discovered post-pandemic) always affect investor sentiment. And, as we already learned, hidden leverage can expose systemic vulnerabilities.
Conclusion
We believe as portfolio managers in a family office, investing in credit with an active focus is essential for our overall portfolio targets. In our experience, finding the right fund manager makes all the difference and that’s why we do spend considerable time with our credit managers and perform intensive due diligence on single credit level before committing to a new manager or strategy.
Please note: Credit is complex. We know that. But we believe that if you are rigorous in your analysis, complexity becomes your friend, because complexity can drive higher returns or lower risk.4
What is your experience in investing in todays environment? Please leave a comment or contact us directly.
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