Feature – Private credit
Traditional banks will con- tinue to play a vital role in the financing of economies, but private debt funds will continue to gain a higher
share of the funding pie. Stéphan Caron, Blackrock
with a shift from active liquid allocations in favour of private equity allocations – whereas fixed income is still in the early stage of this evolution,” he says.
A vast universe For Desforges, it is pension pools like Border to Coast which have spurred on facets of private credit. The direct lending market: senior secured/uni-tranche debt, which is the most senior part of the capital structure with a relatively low level of risk and volatility and where the strategies are the least com- plex, is estimated to be worth $1trn (£780bn) and has been funded primarily by insurers, pension funds, endowments and sovereign wealth funds.
There are barriers to entry in terms of making a £500,000 minimum commitment and more sought after managers can be hard to access. Waldron makes the point that at one end of the spectrum, pri- vate markets can be as complex as significant risk transfers, or fairly simple lending mechanisms such as leverage loans. “What they do consistently offer is an opacity and skill premium,” she says.
Therefore, the benefits for including private capital in a portfolio are significant. “Given the breadth of the sub-asset classes within the universe, we believe private markets can offer investors unique diversification opportunities to help complement their existing portfolios,” Waldron says. Indeed, the range of options within the private credit universe is another part of its appeal, as it ranges from private corporate lending to consumer finance, real assets lending and struc- tured credit – all of which have different underlying risks and performance drivers.
22 | portfolio institutional | September 2023 | Issue 126
“Some are liquid, others are illiquid, some are investment grade, others high yielding, but most are cashflow generating propositions,” Waldron says. “This provides opportunities for investors seeking a secure stable income stream returns at dif- ferent stages of the cycle.” Waldron also highlights an important point that gaining entry to the private credit universe needn’t be a challenge for inves- tors. “As private markets continue to grow and develop, improved accessibility via a semi-liquid fund structure, and wrappers such as European long-term investment funds and long term asset funds are helping to redefine alternatives and opening the doors to unique opportunities across the private credit spectrum,” she says. In addition, it’s important to note that there are two distinct markets within private credit – investment grade and high yield. “Investment-grade private credit has demonstrated its resilience over several economic cycles,” Sun says. “High yield private credit – which includes direct lending – has a more lim- ited track record as the asset class grew significantly in benign market conditions after the global financial crisis.” Sun, therefore, sees credit risk as becoming a more dominant driver in the coming months, as investors renew their focus on fundamentals, making asset selection critical. “Thorough due diligence, pricing discipline and stress testing in place are all essential to delivering strong long-term returns in private credit in our view,” she says.
Re-pricing
The recent re-pricing in private credit serves as another oppor- tunity for investors. “Yes, we believe private credit is attractive,” says Desforges, reinforcing the re-pricing narrative. “For the lower risk direct lending strategy, the gross returns available have risen from around 8% in the first quarter of 2022 to around 11%, which has been driven by a move up in interest rates and a widening of credit spreads.” But there are issues. The net return, after fees and expenses, will be lower, while managers are factoring in higher than his- torical losses. However, Desforges, says: “The net return will still likely be an attractive 8% to 9%, which compares well against the 6% net return that was anticipated for the strategy in early 2022, with a lower level of assumed losses.” For Caron, the re-pricing has created some complexity. “As we attempt to balance the narratives from multiple economic and market indicators, for allocators this creates a complex invest- ing environment, which argues for focusing on quality compa- nies with sustainable cashflows in defensive sectors,” he says. Long-term “mega-forces” still offer investment opportunities, he says. “Be that in healthcare, digitalisation or in the transi- tion to a low-carbon economy.
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