Over the past decade, private credit experienced a number of tailwinds that boosted the demand for the asset class from both institutional and private investors. Today, the private credit market is estimated to stand at over USD $1.5 trillion. Below we discuss what private credit characteristics are and the benefits of adding an allocation to your investment portfolio.
Private credit includes a number of strategies ranging from senior secured loans for corporate borrowers, to unsecured loans for financing construction, to loans against specialised assets or revenue streams like royalties. Different loans carry different types of risks and can generate a range of returns commensurate to that. Returns also include different levels of yield and capital appreciation components. Senior secured loans offer relatively stable yield while unsecured subordinated and mezzanine strategies provide higher yield to compensate for the additional credit risk. Distressed and opportunistic strategies target firms undergoing meaningful challenges. They typically have the highest level of risk and often no yield component. However, they also have the potential for higher upside as the companies are restructured.
The diversity of private credit strategies and their characteristics means that a private credit portfolio can be structured to target a broad range of objectives and can be customised to an investor’s individualized goals. Private credit can play an important role in traditional investment portfolios, offering income generation, return enhancement, and diversification.
The main advantages of adding a portfolio allocation to private credit strategies include:
- Income generation
Over the past decade, the asset class has generated attractive yields relative to most other asset classes. As borrowers’ access to capital became more restricted post the GFC as banks pulled back due to regulatory capital constraints, borrowers have been willing to pay a premium for the certainty of execution, agility, and customization that private lenders offer.
- Capital Stability
In a private credit market, lenders negotiate directly with borrowers. Therefore, there are often controls in place that allow for ongoing borrower reporting obligations which provide protection and early warning of risks. As a result of the protections in place, the corporate loan loss rates have generally been low for many years.
- Diversification
Some private credit strategies are most directly exposed to the economic health of corporate sector, others to the consumers, others to real assets. Corporate and real asset-linked credit tends to move with the economic cycle. Others, such as distressed and opportunistic, may be more counter cyclical, finding more attractive opportunities when the economy is experiencing a slowdown.
Private credit benefited from higher interest rates in 2023, partially due to the floating-rate nature of the asset class. Going forward, even if there is a turn in the interest rate cycle, the opportunity set continues to look attractive on a risk adjusted basis. However, the asset class is not immune to investment risks. Some of the risks specific to private credit to consider include illiquidity of the asset class, leverage levels, credit quality and default rates.
Similarly to other asset classes, investment and operational due diligence is important when selecting the right investment opportunity. It is suggested investors consider the track record of the private credit managers, their ability to structure loans, construct diversified portfolios and deploy capital in a prudent manner.