Private credit: Everything old is new again

Private credit has garnered a lot of attention recently, touted by many as the latest go-to debt investment in the alternatives boom. It is an intriguing phenomenon to those of us who have worked in the loan markets for decades.

Money has been lent by banks to companies since the 14th century, and money has been lent by companies to companies for decades. The fact that lending is now labeled as the hot new thing is more the result of a structural shift in capital markets rather than any fundamental changes in lending itself. As the old saying goes, everything old is new again.

Private credit – a big basket of debt including infrastructure, distressed, real estate, mezzanine, direct lending and more – was borne out of a major financing gap for small and medium-sized companies left behind by the 2008 global financial crisis. The low yield environment between 2009 and 2021 fueled exponential growth of the asset class.

Put another way, private credit and more broadly alternatives have improved, and many would say democratized, access to capital for companies. Given the increased market concentration of publicly listed companies in recent years, private credit expands the opportunity set and offers a source of diversification and potentially attractive returns and income. Although the convergence of changes are the real story behind the hype, we believe private credit is a differentiated offering. The addition of private credit to a traditional 60/40 equity and bond portfolio could allow investors to achieve a desired level of return for a lower or comparable level of risk.

To a great degree, the parts of credit markets we focus on are long-standing. We look at non-investment grade debt across the public and private credit spectrum – syndicated loans, high yield, structured credit and direct lending – and investing in loans is labor-intensive. It requires vast experience and hands-on due diligence. This is key to uncovering market inefficiencies and incremental premium.

Not only are we mindful of the past, one of the tenets of our investment philosophy is preservation of principal. We don’t chase returns because, unlike equities, the gains in basis points from a more risky loan will not make up for a principal loss. We are in an asset class where credit selection is paramount, and being disciplined and not taking unnecessary risks is a main reason we have found success through both bull and bear markets.

In the near term, overall non-investment grade debt is benefiting from the high interest rate environment, but we find loans and direct lending particularly attractive at the moment. In addition to high base rates, large risk premiums compared to history also add value to these asset classes.

We also like collateralized loan obligations (CLOs) on a relative value basis. Thanks to their capital structure, AAA-rated CLO debt tranches (also called mezzanine tranches) are delivering comparable spreads and returns as similarly rated investment grade corporate debt. We also see a similar story with CLO equity tranches.

Longer term, these asset classes should continue to do well as interest rates will likely remain elevated for some time – and income generation will also continue to be a priority for a global population that is aging.

For senior loans, their floating rate nature makes a much steadier return profile and provides insulation against surprises and inflation. They offer a more constant way to take advantage of the higher rate environment. Since 1992, senior loans (as measured by Credit Suisse Leveraged Loan Index) have generated positive returns 28 out of those 31 years.¹ The appeal of consistent returns with relatively lower volatility from loan asset classes make them a bedrock allocation in our view, which could be tactically complemented by high yield depending on market conditions.

Amid all the hype surrounding private credit, there are also concerns. Some within the financial industry have emphasized the illiquidity, lock-up periods and other more inherent risks associated with the asset class. Others, such as the International Monetary Fund, have warned on various potential fragilities, centered around borrower creditworthiness, underwriting standards, imprecise valuations due to infrequent mark-to-market, borrowers being more leveraged than the typical bond issuer, and lastly the concentrated exposure to the asset class of some institutions.

However, we believe the risks can be mitigated in a number of ways. Firstly, we have the size and scale, and in the loan markets this matters. Our established long-term relationships with lenders and borrowers mean that we know our partners well. Not only do we have allocation priority, we have strong visibility to the pipeline of the primary market as well as the secondary market, allowing us to identify the best opportunities across markets.

More importantly, we know where the problems lie. At a high level, even though companies entering defaults or distressed exchanges are still accelerating this year, particularly in the US and Europe, our credit outlook is positive. Transactions facing problems tend to be idiosyncratic in nature since the underlying health of the market continues to be resilient from our perspective. We do not expect a cyclical upturn in the default cycle.

On a company level, fundamentals appear strong to us. Based on our bottom-up credit analysis, we work with a diversified set of companies, and a shared characteristic of what we look for is that they all have a steady cash flow, are resilient and tend to be successful in navigating difficult times. In addition to a clear view into which sectors are doing well and which are not, we have the experience, size, breath, network and knowledge to distinguish between good and bad borrowers. As a result, our investments have lower default rates than the broader private credit market.

It is important to note that accessing private markets requires a well-defined strategy, and different asset classes should not be viewed in silos or evaluated only as standalone allocations. When considering the benefits of asset classes, investors ought to look at the whole picture and how each asset class can complement each other to meet overall investment objectives.

Ultimately, private credit can provide a strategic source of income in a well-diversified portfolio for risk-tolerant investors.

1. Source: Credit Suisse. Data from January 1992 to December 2023.