June 17, 2019
Justin Lenarcic, Global Alternative Investment Strategist
The Not-So-Secret World of Private Credit
- Private credit strategies may seem secretive and complex, but they share many similarities with public credit (e.g, corporate or securitized bond markets). The key difference is the type of borrowers to which private credit investors typically lend—and the structure of those loans.
- While a large amount of capital has been allocated to private credit strategies, especially those focused on direct lending, we expect an abundance of potential opportunities to exist as the U.S. credit cycle matures.
What it May Mean for Investors
- For qualified investors, private credit strategies historically have generated a higher yield and return—with lower defaults—than public (corporate) credit has.1
A simple definition of private credit can be hard to find, and even harder to understand. Terms like capital relief, rescue financing, or even direct lending can be both intuitive and ambiguous. They can confuse investors who perceive this asset class as secretive and overly complex. But the truth is that private credit strategies are quite similar to their public credit counterparts—where the common foundation is simply the act of lending and receiving interest (and principal) in return.2 There are several differences, but the world of private credit isn’t nearly as secretive as it may appear to be, in our view.
Defining private credit
Perhaps the best way to define private credit is to start with what it isn’t. Public credit is generally defined as either corporate or securitized credit. Corporate credit includes investment-grade (IG) and high-yield (HY) debt securities, along with emerging market debt. Leveraged loans—or bank loans—fall within the corporate credit sector.
Securitized credit focuses on debt backed by assets such as residential and commercial real estate, student and auto loans, credit cards, and collateralized loan obligations (CLOs).3 Mutual fund and exchange-traded fund (ETF) investors can invest in securitized credit, but the focus often is on IG debt, for which liquidity typically is sufficient. Truly capturing the illiquidity premium offered within securitized credit requires a longer-term investment horizon.
What makes private credit private?
The banking sector has seen steady consolidation for decades—more recently accelerated by increased regulation following the financial crisis. This has led to an increase in nonbank lending, and it formed the foundation of the private credit market. Because the ultimate holders of public credit are removed from the origination process, they have little control over the structure of the bond or other financing vehicle, or over the pricing.
Private credit is different in that it is a much more “hands on” approach. Covenants and deal structure are actively negotiated between borrower and lender, giving private credit investors much more control over the loan, which ultimately (and hopefully) results in greater control over risk and performance. Within securitized markets, private credit investors can parse through pools of loans, selecting only those to which they want exposure.
Common private credit strategies
Private credit tends to be a catch-all category for a variety of strategies, but below are a few of the more common sub-strategies.
- Direct (corporate) lending: Smaller, middle market companies have turned to private credit investors to secure bridge financing or capital for other bespoke opportunities.
- Direct (residential) lending: In some instances, legacy (pre-crisis) mortgages that may be delinquent or need modification can be purchased and cured. Other strategies involve purchasing mortgage servicing rights (MSRs) from banks to assist with Dodd-Frank regulations.
- Specialty finance: Also known as trade finance, this strategy normally involves purchasing a pool of insured receivables from a small business or large corporation that needs the capital before the receivables are delivered.
- Regulatory capital relief: Brought about by the financial crisis and the regulatory overhaul of banks, regulatory capital relief transfers credit-loss risk from financial institutions’ balance sheets to private investors.
- Rescue finance: Occasionally, good companies have unexpected liquidity shortfalls or temporary operational problems. These companies may not qualify for bank loans and may need an alternative source of financing.
Benefits of being “private” late in the credit cycle
With yields on traditional fixed-income securities near historic lows, many investors are looking for ways to enhance their income. Compared to traditional public (e.g., corporate) credit, private credit historically has generated a higher yield and return, with lower defaults.4 Furthermore, private credit often has floating-rate coupons, making it a potentially attractive hedge to increases in interest rates.5
As Chart 2 shows, the amount of capital raised for private credit remains high, even considering a pullback in 2018. While certain strategies, such as direct lending, have seen a significant increase in dry powder, there are multiple avenues for private credit investors to take. We anticipate that rescue financing and other forms of distressed and special situations strategies could be well positioned as the credit and business cycles mature.
We expect public credit market risks (particularly in HY corporate markets) to increase going forward. Within the alternative investment space, such an environment can lead to greater opportunities for private credit investors. As lending conditions tighten, alternative forms of financing will become more important. While the growth of the private credit sector bears consideration, we believe that diligent, private credit investors that methodically allocate capital will have no shortage of opportunities.