January 20, 2020
“56% of global respondents plan to increase their allocations to private credit.” – BlackRock 2019 Global Institutional Survey
The fact that over half of the institutional investors in BlackRock’s survey said that they were rebalancing their assets towards private credit should come as little surprise: figures provided by Deloitte show that, if it continues on its current trajectory, private credit is set to surpass real estate as the third largest alternative asset, by 2023.
What makes it so compelling?
For one thing, private credit is a much broader asset class than the name suggests. Aggregated private credit figures are composed of corporate direct lending, real estate debt, consumer lending and a range of other specialized forms of finance, from agriculture to infrastructure. For investors with higher risk appetites, distressed and secondary credit can create opportunities for sub-strategies that generate equity-like returns.
This range of investment options allows investors in the traditional “60/40” allocation of equities and bonds to lower volatility and enhance returns by diversifying into private credit. Because most private credit is floating rate, it also offers minimal duration risk. And implemented correctly, investing in private credit provides considerably more downside resilience than public equities as covenant-bound loans can be made to specific firms whose returns have little correlation to the overall market.
The shift towards private lenders
One of the manifold consequences of the Global Financial Crisis was a rethink of private credit. Traditionally, large financial institutions such as banks and insurance companies dominated in the sector. However, as is by now well documented, the mismanagement (and misrepresentation) of this debt by those same institutions was a contributing factor to the financial crisis that followed. More stringent regulation was introduced, forcing banks to shore up their balance sheets and reduce their holdings of private credit.
From a dominant position in the market, banks and other financial institutions’ share of the private credit market has fallen to less than 10%. It’s not as though the middle market requires less debt than it did a decade ago: Prequin estimates that private credit more than tripled between 2007 when it was $205bn, to 2018, when it hit $638bn. The difference between then and now is the greater participation of non-banking institutions – none of which suffer from the moral hazard that that underpinned much of the behavior of banks and insurance companies in the lead up to the GFC.
Plenty of runway
Talk of a bubble in this sector is likely to be premature. With more than $15 trillion of negative yielding corporate and government debt outstanding, it’s not going to be easy to make money with a traditional asset allocation any time soon. Further opportunities to take advantage of private credit await in Europe, where a new wave of regulation is likely to force banks to unload yet more of the private credit that sits on their balance sheets. A decade after the crisis, EU banks still hold in excess of $1 trillion in non-performing loans.
For these reasons, although the rapid growth of private credit among non-banking institutions may raise eyebrows, its growth is far less likely to constitute a bubble than simply the natural evolution of a nascent asset class. With a recession sure to arise somewhere in the not-too-distant future, sensible private credit also offers investors an excellent opportunity to offset falling asset prices. And should interest rates rise, the fact that nearly 90% of private credit is floating rate makes it an attractive jumping off point.
None of this is to say that private credit is a panacea. Even the most ardent advocates of this asset class stress the need for higher levels of due diligence and a more detailed understanding of the borrower’s financial standing and where its market is in its cycle. Likewise, the attractive returns and lower volatility of the asset shouldn’t mean that covenants can be loosened. If there is an issue with private credit, it’s that covenant-light debt has multiplied over the past decade – irresponsible practice, even in an attractive segment of the market.
Private credit relies less on broad market trends and more on the strength of each specific investment. For individuals facing retirement, institutions looking to satisfy long-term pension liabilities or even private investors looking for alternative investments, it offers high current income, low correlations with public markets and lower default risks than yield spreads would imply. With adequate covenants and a well-focused strategy, private credit offers a broad range of opportunities to RIAs, wealth managers and private investors to avail of above-market returns with a managed downside.
2Based on figures provided by Wells Fargo and S&P Capital IQ’s LCD.