6 February 2023
While investors have long relied on bonds and broadly syndicated loans to generate yield, the growing prominence of private credit is expanding the universe of income investing. But what exactly is private credit, and how can investors benefit by allocating to this asset class?
Investing in private credit—also known as or direct lending—usually refers to loaning capital to an unlisted company or group of companies, although it can also include privately negotiated loans to public companies. Investors holding public credit—say, a corporate bond or broadly syndicated loan—can generally sell whenever they please. Liquid credit markets serve as a massive, global intermediary between countless borrowers, or issuers, on the one hand, and an even larger number of lenders, or investors, on the other. After the primary offering of a bond or broadly syndicated loan, it can change hands relatively easily, as unnamed investors around the world trade debt daily over the counter. By contrast, as those who’ve taken out a personal loan or mortgage can appreciate, the realm of private credit resides in a direct business relationship. A private credit transaction can involve a single lender who’s more committed to a long-term relationship with the borrower, often lasting through the life of the loan, which can average three to five years. In exchange for this commitment to financing the business, private credit investors usually earn on more customizable terms than investors in comparable public credit.
Characteristics of private and public credit instruments
|Private credit||Bank loans||High-yield bonds|
|Also known as||Private debt, direct lending||Broadly syndicated loans, leveraged loans||Non-investment-grade bonds|
|Coupon rate||Floating (for senior credit)||Floating||Fixed|
Source: Mercer, Manulife Investment Management, January 31, 2023.
Private credit isn’t a monolithic asset class. It includes subcategories as diverse as investment-grade private placements, real estate debt, and venture capital loans. Loans mainly fall into two categories: corporate loans (financing companies) and real asset loans (financing things). Two of the more significant opportunity sets for investors in corporate loans include and . These strategies invest in loans made to midsize, well-established businesses. What distinguishes senior credit from junior credit is where those loans reside within a company’s capital structure. Real asset loans refer to private debt financing, where the borrower puts up physical assets as collateral in the case of a default. Private originated asset-based loans, secured by real or financial assets, can serve as a complement to both private credit and traditional fixed-income strategies. Meanwhile, distressed debt, opportunistic credit, and special situation strategies involving bankruptcies and restructurings can offer control and capital appreciation opportunities (and associated risks) more typically associated with private equity investing.
Unlike their larger-cap peers, middle market companies, those with annual revenues between $10 million and $1 billion, are frequently too small to tap the public bond market, and they’ve historically turned first to commercial banks for debt financing. However, the banking industry has been backing away from following the global financial crisis.
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The bankers’ retreat has created an opportunity for non-bank investors willing to step in and lend directly to businesses. While lending dynamics in the bond markets tend to be driven by price alone, private credit markets are smaller, more fragmented, and less efficient, and the value of human plays a much greater role in making deals happen.
Private credit offers a current yield premium for investors
Source: Cliffwater, as of September 30, 2022; FactSet, as of December 31, 2022. See notes for details.
Investors in private credit give up liquidity to pick up yield. While the illiquidity premium associated with directly originated upper middle market loans has ranged from 150 basis points (bps) to 280bps in recent years, it resides closer to 240bps in the current market.1 While premium yields may be the defining feature of the asset class, the potential .
Source: Cliffwater, as of September 30, 2022. Past performance is not indicative of future results.
Private credit has a history of muted drawdowns amid macro headwinds; it’s also performed well with economic tailwinds. Relative to the liquid credit of larger companies, direct senior loans—which are first in line to get paid in a company’s —have demonstrated higher recovery rates and lower default and loss rates given the stronger covenants and tighter alignment between equity owners, lenders, and company management.
Source: S&P Global Market Intelligence, Refinitiv, as of December 31, 2020.
Market inefficiencies in private credit can also lower leverage levels and make deal structures more attractive for investors. Private credit’s consistent recurring cash distributions can also lower the price volatility of direct loans, which, unlike corporate and broadly syndicated loans, aren’t marked to market.
Direct senior loans can offer a measure of interest-rate protection. Floating-rate benefits increase quarterly distributions to investors when interest rates rise, and floors protect investors’ income when interest rates fall. As multidecade record levels of inflation have prompted central banks to hike interest rates, private credit investors have kept pace, unlike their counterparts investing in fixed-rate bonds.
Private credit assets are generally long-term investments, less affected by the short-term price movements of securities listed on the world’s public exchanges. Still, as with any investment, allocating private credit involves a range of risks, including those that can lead to permanent loss of principal.
Because debt investing hinges on issuer solvency, the first risk is , the risk that the issuer won’t meet its payment obligations on time, in full, or at all. It’s relevant in both liquid and private credit markets. Managing credit risk means generating income with careful issuer selection and vigilant monitoring of issuers. When investors are starving for yield, it’s worth remembering that companies often have little difficulty raising capital through debt issues, even when their fundamentals don’t support them. Credit risk also involves discipline about pricing. Tight spreads can get tighter and wide spreads wider, but managers who have experienced several market cycles have a natural edge over those who have only worked in the latest market regime.
Relative to corporate bond and broadly syndicated loan markets, private credit assets are subject to lower levels of . Liquidity—the extent to which a position may be sold at or near its net asset value—may be further impaired by heightened volatility, rising interest rates, and other market conditions.
While subscription lines to aid capital calls during the investment period are nothing new, some managers have more recently used them to ratchet up returns; in fact, most senior credit strategies in the market offer a levered option. While leverage can indeed increase the magnitude of potential gains, it can also increase the magnitude of potential losses.
Private credit’s early adopters accessed the asset class through traditional drawdown funds whose high minimum investments generally favored pension plans, insurers, and other large institutions. However, the market is evolving to include feeder funds, interval funds, unlisted closed-end tender offer funds, and other semiliquid structures that can accommodate smaller allocations, thereby opening the segment to smaller institutional and individual investors. Developments in financial technology—specifically, specialized platforms that can consolidate individual investor accounts into a combined pool of capital for general partners—have played a role in broadening access to private credit. While firms offering private credit capabilities now get to diversify their client base and tap high-net-worth and mass affluent capital previously unavailable, more and more income investors, in turn, get to diversify their portfolios beyond corporate bonds and broadly syndicated loans.
1 Cliffwater, September 30, 2022.
Private credit is represented by the Cliffwater Direct Lending Index (three-year takeout yield); high-yield bonds are prepresented by the Bloomberg High Yield Index (yield to worst); bank loans are represented by the S&P/LSTA Leveraged Loan 100 Index (yield to maturity), as of September 30, 2022. Corporate bonds are represented by the Bloomberg U.S. Corporate A Investment Grade Index (yield to maturity); U.S. Treasuries, Singapore government securities, and Japanese government bonds are represented by 10-year yields, as of December 31, 2022.