Private credit – Feature


Over the past couple of years, debt funds have sought to add some juice to these lacklustre returns, either by leveraging the fund itself or by taking on broader exposure through


the capital structure. Grant Murgatroyd, Preqin


surged between 2010 and 2012, but managers subsequently suc- ceeded in deploying the capital. However, the macroeconomic environment is different to how it was 10 years ago, with inflation on the rise, central banks raising interest rates and the mid-sized businesses commonly targeted by private market investors are already struggling with the effects of the pandemic. But perhaps the biggest and least mentioned concern with high levels of dry powder is its impact on returns. It is all well and good if ever growing numbers of capital are deployed with an ever shrinking number of asset managers. But if that cash does not result in additional funding for businesses like Bus Patrol, returns will be hit.


And returns have slumped, as Preqin’s data shows. Private cred- it’s internal rate of return has fallen from double-digit figures 10 years ago to low single digits during the past three years. Grant Murgatroyd, senior writer at Preqin, warns that this has been camouflaged by increasing leverage. “Over the past couple of years, debt funds have sought to add some juice to these lack- lustre returns, either by leveraging the fund itself or by taking on broader exposure through the capital structure.”


Systemic risks Ever mounting levels of dry powder have turned private credit in


to a borrower’s market. Ratings agency Moody’s warned in a report at the end of last year that “systemic risks” had built up in the sector. The ratings agency warns of a deterioration in credit quality combined with a rise in leverage. “Competition between public, institutional and private markets has lowered loan credit quality and allowed for increased docu- ment flexibility, diminishing credit protections for investors,” the report read. “In particular, leverage has risen, which increases downside risk when economic conditions weaken, while rising shares of distressed companies can weaken productivity and lead to misallocation of capital to unhealthy companies.” The ratings agency also warns of the increasingly blurred bound- aries between private credit and debt. “The decline in leveraged finance credit quality is driven by the aggressive financial poli- cies of private equity sponsors,” the ratings agency warns. Moody’s estimates that within the distressed debt universe, some 70% of debt is owned by private equity firms. It also high- lights that among the top 12 private equity portfolios in the US, all firms had a leverage of six times their average earnings before EBITDA. The market has also become increasingly concentrated, geo- graphically and in terms of players, particularly at the lower end. Some 61% of all private credit is held in the US and four of the 10 largest private credit funds swooped up some $16bn (£12bn) of the $23bn (£17.4bn) in distressed debt deals. The systemic risk lies in the combination of these two factors, increased leverage and fund manager concentration, warns Moody’s, as the defaults could spark a domino effect.


Digging deeper


Does all this mean that pension funds should stay clear of pri- vate credit? The PPF’s Bhudia stresses the importance of bot- tom-up research and having realistic expectations in terms of liquidity. Because the PPF invests in investment-grade debt on a buy-and-hold basis, liquidity is less of a concern. But this also requires thorough research of the companies the PPF invests in. “We use models which mirror those of rating agencies to get a risk assessment of the firms we invest in and use that in the sec- tors to match with public comparators. We assign a credit risk rating to all assets we invest in and that is constantly evaluated,” she says. “We will spend a lot more time before we invest in private credit to make sure it is completely safe. For the investment grade side, the reporting requirements are embedded in the loan documen- tation, so we know exactly what level of information to expect,” Bhudia adds.


“Our experience is that it is far easier to access information because we are often a principal lender, or a significant lender. But you cannot just wait for the annual accounts to come up. If you ask the questions, you will usually get a response.”


April 2022 portfolio institutional roundtable: Fixed Income 33


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