The Nobel Peace Prize winner and former Chancellor of Germany Willy Brandt in 1971 declared ‘those who adhere to the past won’t be able to cope with the future’; prophetic words that hold true across the 2023 financial universe.1
After decades of declining and ultra-low interest rates, the velocity and magnitude of global rate rises, and tightening credit conditions has dominated the investment landscape. Macro shocks, like the regional banking turmoil in the US, served as a timely reminder of the importance of managing financial risk. A direct by-product of the steepness and severity of the recent monetary tightening cycle, more shocks may occur.
Private credit offers investors the potential to preserve capital and generate resilient and regular income. It provides an opportunity to lend against high-quality assets with equity-like return upside, has low correlation to other asset classes and is a compelling and defensive floating-rate alternative option to cope with the future (however that plays out).
What are the opportunities in private credit, why is now a good time to invest and what role can it play in optimising portfolio allocation?
What is private credit?
Private credit is a bilateral lending arrangement by a credit provider directly to institutional borrowers (as distinct from public bond markets or bank lending) with bespoke structured terms and covenants directly negotiated between a non-bank financier and a borrower.
Private credit transactions are by nature proprietary, sourced with pricing and bidding uniquely structured through a tailored and specific arrangement based on the requirements of the investor (lender) and the borrower (and not transacted via a public exchange).
Lending outside the traditional banking sector or corporate bond market, private credit is generally considered a defensive asset offering capital protection due to its position in the secured debt section of the capital structure. It is a floating rate asset class, meaning returns are directly linked to the base cash rate, well-positioned to take advantage of volatile financial markets while at the same time offering a predictable income stream secured via contractual borrower agreements.
Private credit offers greater investor control and protection due to the ability to engineer the level of seniority in the capital hierarchy or security pool of the lending company or asset (depending on the type of credit). It also offers a wide range of strategies, products, and access points for all types of investors.
A deep universe
Private credit is a deep universe, spanning a complex and diverse spectrum of instruments, borrowers, counterparties, and asset pools across a wide array of sectors.
From diversified, asset-backed lending (including real estate credit) to more specialised bespoke capital solutions, myriad opportunities abound for non-bank financiers to take advantage of the retreat of traditional banks from certain segments of the debt market as capital regulatory changes dictate.
The assets of private credit funds consist of a range of strategies including direct lending, venture debt or special situations provided as senior, junior or mezzanine debt to both listed and unlisted corporates, as well as for real estate.2 Funds dedicated to private credit (including direct lending and other strategies) raised over US$200 billion globally in 2022.3
The rise of private credit
Structural shifts in regulatory capital requirements have forced banks to be less active in certain segments of both the corporate and real estate lending market.4 This has supported the rise of private credit market solutions. Major regulatory changes occurred at the same time as institutional investors increased their exposure to private markets more generally in search of income yield in the prevailing ultra-low interest rate environment of the time.
The profound sustained and fundamental changes to the investment landscape is motivating investors of all types to reconsider how to protect and growth wealth and diversify outside the traditional public equity and debt markets.
The historical rules dictating asset allocation no longer necessarily prevail. The concept of a ‘risk-free’ rate has been rocked by gyrating bond markets. Surges in 10-year bond yields and the UK gilt crisis has led to a re-assessment of the role of public market debt in providing capital protection.5 The US banking crisis has added a new layer of opportunity for non-bank lenders.
No longer supported by a low interest rate regime and with significant volatility across the financial markets, private market investing offers an increasingly attractive alternative to public assets (where price and valuation are likely to remain under pressure).
With the suite of private market alternative options expanding (including private credit funds) there are increasing investment opportunities, not just for institutional investors but a wide range of investor groups including high net worth and retail investors.
Floating rate credit is well suited to current conditions
Conditions for floating rate private credit are the best they have been for a generation.
With higher interest rates, heightened volatility and uncertainty permeating financial markets, private credit benefits from the upward movement of interest rates occurring at the same time as the regulatory environment exerts pressure on traditional banks to secure their balance sheets.
In the hands of an experienced manager with multi-cycle experience, the position of debt (credit) in the capital structure and its floating rate nature can reduce income volatility and downside risk. Investors should choose asset managers carefully, based on the scale and depth of their platform, the depth of embedded governance, the experience of the lending team, and an established track record through multiple cycles.
The opportunity in private credit | Challenges remain for publicly traded assets
Long-term investors have faced two major shifts in the investment environment.
One has been steadily building (the rise of private assets to the core of investment portfolios) while the other materialised relatively quickly (rocketing interest rates and a prolonged period of macro uncertainty).
Both require a fundamental re-think of the asset allocation process.6 The benchmark portfolio (60% equities, 40% fixed interest) took a significant hit during 2022 heralding a paradigm shift in capital allocation to a more defensive position.
Given the uncertain outlook for interest rates, corporate earnings, equity prices and the pricing of risk for public market securities (bonds), private credit is set to expand its reach to occupy a greater proportion of the capital structure, and therefore a greater allocation within investor portfolios.
For more information about our private credit solutions, please get in touch.
- Willy Brandt, speech at the extraordinary convention of the Social Democratic Party of Germany, 18 November 1971, www.libquotes.com
- Preqin, Private Debt in APAC, Japan, South Korea and Australia 2022 www.preqin.com
- Pitchbook, Global Private Debt Report, 2022 Annual, www.pitchbook.com
- The New Dynamics of Private Markets, Winter 2022, PGIM, www.pgim.com
- Three US banks failed in March 2023, triggering a swift response by regulators. Source: The Evolving Nature of Banking, Bank Culture, and Bank Runs. Speech by US Federal Reserve Governor Michelle Bowman, 12 May 2023, www.federalreserve.gov
- MSCI, Building Balanced Portfolios for the Long Run, October 2022, www.msci.com
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