Not all private credit managers are capable of managing a portfolio through the ups and downs of an economic cycle, making manager selection critical.Eoneren/iStockPhoto / Getty Images
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Private credit has experienced rapid growth and evolution over the past decade. It now stands as a US$1.7-trillion asset class, expected to almost double in size over the next five years, according to investment data firm Preqin Ltd. While most of the capital invested in private credit is on behalf of institutional investors, more advisors are recognizing the asset class’s benefits and potential to provide a reliable source of income with strong downside protection for their investor clients.
Yet, navigating private credit can be daunting for advisors because of the number of managers marketing products and the lack of transparent data. Successful private credit investing requires skill and expertise, and not every manager has that edge.
Private credit investments are non-publicly traded investments provided by non-bank entities, such as alternative asset management firms, that fund private businesses. Managers invest in directly originated loans to businesses that can’t or don’t want to access public markets for their capital needs, and private credit investors seek to provide borrowers with tailored solutions.
One feature that generally makes private credit compelling is the contractual return component it offers. There’s a legal promise of return of capital and, in most strategies, a promise of payment of interest or other contractual return.
Private credit investments offer higher yields than traditional fixed income investments by taking advantage of the illiquidity premium, or the potential for excess return for investing in assets that can’t be converted into cash easily. For these reasons, private credit could be viewed as a risk mitigation tool relative to holdings in equities.
The single largest strategy within private credit is direct lending, which accounts for close to half of overall assets in this category. Direct lending investments are middle-market loans, primarily cash-flow based, and are typically first lien – that is, they sit at the top of a company’s capital structure with the first claim on a company’s assets in bankruptcy, thereby limiting potential losses from defaults.
A significant portion of borrowing in private credit is done by companies backed by one or more private equity firms. That’s important in times of financial stress as the private equity sponsor may provide an equity injection to help the borrower stay afloat, thus reducing credit risk. Historically, these “sponsored transactions” have helped private lenders generate relatively stable returns for their investors over long periods.
Private credit has outperformed comparable below-investment-grade public market fixed income indexes. For the 10-year period from Jan. 1, 2014 to Dec. 31, 2023, the Cliffwater Direct Lending Index returned 8.84 per cent, outperforming the Bloomberg US High Yield Index and Morningstar LSTA US Leveraged Loan Index by 4.25 and 4.43 percentage points, respectively (these figures are in U.S. dollars). The Cliffwater index was the first published index tracking the direct lending market and currently covers more than 15,000 directly originated middle-market loans totalling US$337-billion.
One of the important benefits of private credit investments is they’re affected less by market beta and investor sentiment. They’re not subject to the mark-to-market volatility investors experience in publicly traded fixed income assets, particularly evident in risk-off environments during market downturns.
For example, during the 10-year period ended Dec. 31, 2023, the Bloomberg US High Yield Index declined in value in three calendar years (2015, 2018 and 2022). In those same years, the Cliffwater index generated positive returns, demonstrating private credit’s resiliency in times of market stress.
As with all private market investments, performance dispersion in private credit is wide. Selecting top-tier managers is essential for tapping into the asset class’s full potential and earning an illiquidity premium. The two pillars of successful private credit investing are deal origination and underwriting. Partnering with managers that have a proven track record, expertise in assessing credit risk, and a history of recovering investments is essential.
The good news for Canadian advisors and their investor clients is they now have access to a broad array of private credit fund offerings from top-tier global managers. These offerings include open-ended evergreen fund structures that offer certain redemption features.
In today’s market environment, private credit looks appealing given the opportunity to earn significantly higher cash yields relative to several years ago – yields that are comparable to or higher than the long-term average of equity indexes.
The flip side is that having to pay those higher rates of interest can cause stress at the individual borrower level. Advisors and investors should recognize that not all credit managers are equally capable of managing a portfolio through the ups and downs of an economic cycle. As is always the case with investing in alternatives, manager selection is critical.
Sean O’Hara is co-founder and chief investment officer at Obsiido Alternative Investments Inc. in Toronto.
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