A note from Dan - Why private credit has been winning strong investor support

There has been no lack of financial media coverage of private credit in recent times, which makes it timely for us to join the conversation and offer our thoughts on the asset classes’ rapid growth.

Private credit, when managed to institutional standards, offers what we consider to be attractive risk-adjusted returns coupled with strong structural and contractual protections. More specifically, its high ranking in the capital structure, a theme we dive into later in this note, provides institutional investors a margin of comfort.

Key facts

Though private credit has been an institutional asset class since the late 1990s, the sector really took off post the GFC gaining strong investor support with assets under management reaching around US$1.7 trillion in mid-2023 (Chart 1).

Chart 1: The private credit market has grown rapidly…
Assets under management for all private debt strategies (US$ billions)

Data is as at June 2023. Assets under management data is reported with a 6-month lag
Source: Preqin

Banks were forced to pull back their presence in traditional capital lending markets owing to GFC-related regulatory changes designed to dampen systemic risks. Their withdrawal from sub-investment grade lending reduced an important funding source for many firms, primarily in the US, but also in Western Europe, and to a lesser extent in Asia too.

The void left by banks has been filled by an ever-growing number of specialist private credit managers (Chart 2) who lend directly to commercial borrowers, with “direct lending” being a common description of the asset class.

Chart 2: …as has the number of private credit managers

Source: Preqin

Private credit/direct loans have shorter maturities than many government and corporate bonds with loan terms typically being around 3 to 5 years, however the loans are illiquid as they are not tradeable. Owing to this illiquidity, private credit investors expect a return premium in the order of 100 – 200 basis points over Broadly Syndicated Loans (BSLs are a form of bank-led loans involving multiple lenders).  

Private credit returns over the 2013 – 2023 decade confirm that the asset class has, at least historically, delivered on return expectations (Chart 3) having outperformed publicly tradeable debt assets such as BSLs and high-yield bonds.

As a private non-tradeable investment, the private credit asset class has exhibited less volatility than publicly traded markets (Chart 3). While both public and private credit markets are driven by credit quality, public markets tend to be more volatile owing to mark-to-market requirements.

Chart 3: Over the long-term, private credit* has delivered a premium over BSLs and high-yield bonds
Comparison of total returns

*Private credit in this chart is represented by “Senior debt”
Notes: Data is quarterly. Senior debt returns are pooled horizon internal rate of return calculations net of fees, expenses, and carried interest
Sources: Bloomberg Index Services Limited, Cambridge Associates LLC, and Morningstar

Risk protections: highest ranking in capital structure, covenants, and floating rate interest payments

No investment is risk-free and private credit is no exception. However, it has structural and contractual guardrails which, we believe, mitigate risks inherent with lending.

For starters, private credit is senior debt in the capital structure (Chart 4) and this category of loan takes precedence for repayment in the event of borrower default. It holds a higher priority within the capital structure compared to more junior debt, as well as equity, and is the security in the capital structure which suffers losses last.

One of senior debt’s key features is that it is usually secured by collateral or assets, granting the lender a “first lien” claim over them. This security measure contributes to its lower risk profile when compared to junior debt or equity.

Due to its lower risk, lenders often offer senior debt at more favourable interest rates than those charged for junior or subordinated debt. This combination of priority and reduced risk makes senior debt an attractive option for both borrowers and lenders seeking stability and security in their financial transactions.

Chart 4: As senior debt in the capital structure, private credit investors have priority of payment in the event of liquidation

Source: Preqin 

Contracts between lenders and borrowers usually contain covenants providing early warnings of deteriorating borrower performance, allowing for lender intervention and the ability to work with borrowers to influence improvement plans, should signs of deterioration emerge.

We believe this ability to design bespoke terms and covenants has contributed to lower volatility compared to other forms of commercial loans.

Floating rate interest paid

Higher interest rates dent the value of fixed income assets as the value of coupon payments fall relative to market interest rates.

However, duration risk is mitigated in the private credit domain as direct lending loans are charged on a floating rates basis, which helps to protect private credit portfolios from rising interest rates, as has been the case over the recent period (Chart 5).

An upshot is that private credit income returns benefit from higher interest rates. Moreover, there is also a level of confidence in minimum income levels because loans are typically structured with an interest rate floor (Chart 5).

Chart 5: Floating rate nature of private credit combined with a base rate floor mitigates interest rate risk

As at 31 December 2023
Source: KBRA DLD Q4 report

Lending standards are being maintained

Fast-growing industries invariably raise fears over the potential for a lowering of standards as participants compete for business. In private credit, clients may be worried that managers may have loosened lending standards to win market share.

So far, at least, the findings are heartening. 

Average net leverage for borrowers – a key financial health metric comparing net debt to earnings before interest, taxes, depreciation, and amortisation (EBITDA) – has increased recently, but remains below 2021 and early 2022 levels (Chart 6)..

Chart 6: Leverage on new direct lending deals is below 2021 and 2022 levels
Net debt to EBITDA* for new direct loan deals

*EBITDA = earnings before interest, taxes, depreciation, and amortisation
As of March 2024
Source: JP Morgan

Furthermore, "covenant-lite” loans, considered riskier as they have less protection for lenders, are not widespread in direct lending deals. According to JPMorgan Investment Bank data, only about 20% of direct lending deals completed during the 12 months to the end of February 2024 were covenant-lite (Chart 7).¹ By contrast, about 90% of syndicated loans were covenant-lite.²

Chart 7: Covenant-lite loans are not widespread in direct lending deals
% of new deals issued over 12 months to February 2024

As of 28 February 2024
Source: JP Morgan Investment Bank

Interest coverage slippage

So far so good. Here comes the but: the average interest coverage ratio (ICR) –– a key liquidity risk metric –– exhibited a significant decline over 2022 and 2023 (Chart 8), indicating borrowers’ weakening debt service capacity.

With average interest coverage of around 2.0x in 2023 versus 3.0x in early 2022 (Chart 8), a significant slowdown in economic conditions could lead to further deterioration of cash flows, as measured by EBITDA, and greater difficulty in making debt payments.

Chart 8: The interest coverage ratio has declined…

This chart plots the average interest coverage ratio across the distribution of borrowers covered by KBRA in a given quarter.
Source: KBRA DLD 

If interest coverage slippage was the sole risk-related data point available, investors would be within their rights to be a little concerned. Of course, that’s not the case and another data point, private credit default rates, are more reassuring compared to the BSL market or high-yield bond market (Chart 9). We think private credit managers’ monitoring of borrowers through loan covenants helps to explain private credit default rates remaining low.

Chart 9: …but private credit/direct lending default rates have been comparatively low
Year-to-date default rates (12-months to October 2023)

Private credit, in this chart, is represented by “Direct lending”
This chart plots year-to-date default rates across various asset classes in 2023 as reported by KBRA DLD
Source: KBRA DLD

Our investment approach: creating tailored private credit mandates

To be clear, covenants in and of themselves do not guarantee avoidance of losses. Manager selection, strong governance, and the due diligence that goes into the selection process provide us with a margin of comfort where we utilise private credit in our portfolios.

The private credit managers we partner with are specialists with long histories of managing credit through investment cycles and the deep resources to carry out remedial action, should stresses appear among borrowers.

Each of our private credit managers specialise in specific parts of the private credit realm by borrower size ranging from large companies to mid-size and even small companies.

Ours is a well-diversified private credit investment program of domestic and global direct corporate loans targeting low double-digit returns. Consistent with our belief in diversification, a wide spread of loans in our portfolios means that our investments are unlikely to be undermined by a single-loan default, which may be the case with highly concentrated portfolios. 

We use our scale to create tailored mandates where we can dictate the investment terms and objectives including covenants, low leverage, and strong interest cover ratios which gives us confidence in borrowers’ ability to make interest payments.

Private credit will, in our view, progress to become a mainstream institutional asset class like private equity or infrastructure and continue to offer attractive risk-adjusted returns when managed to institutional standards, such as ours.

¹ Four reasons to consider private credit despite the headlines. https://privatebank.jpmorgan.com/apac/en/insights/markets-and-investing/ideas-and-insights/four-reasons-to-consider-private-credit-despite-the-headlines

² Ibid

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