You could say private credit has become the cool kid on the block with all the attention these days in the financial news. If you are not familiar with the private credit asset class, this article from Barron’s gives a good description.

In a nutshell private credit makes direct loans with floating interest rates, typically in the low-double digit range. The article points out that these loans aren’t just directly to private companies, but can also include asset-based lending, along with other alternative asset classes. And, these are illiquid funds (limited access to liquidity since they are private) with high minimums which have traditionally limited them to use by institutional investors.

Way before it was cool we were allocating across the spectrum to private credit. And anytime there are massive capital flows into, (or out of) an asset class, it is good to question why and what is going on – a sentiment echoed in the Barron’s article from Barron’s.

A number of structural/macro changes in the markets since the great financial crisis (“GFC”) have buoyed the popularity of this private credit asst class, because:

  • Due to regulatory and risk reasons, banks pulled back from certain types of lending.
  • Yields fell to near-zero, driving investors to new sources of yield, including private credit.
  • The number of publicly listed companies dwindled as startups stayed private for longer (when compared to a traditional cycle) and private equity deployed capital acquiring companies.

The result is a massive increase in invested assets in private credit. Assets have grown approximately 5x,,from $280 billion in 2010 to $1.4 trillion today. Market estimates, such as this one from Moody’s, put the AUM at $2 trillion by 2027. There are signs of success – private credit returned 4.2% in 2022 while traditional fixed income, as defined by the US AGG, was down 13.1% for 2022. Almost seems too good to be true. Let’s take a look at where the downside in the asset class could come from.

Where could the cracks be going forward?

  • Many of the private credit loans underwritten seem to have been covenant-light (“cov-light”), so investors might not be seeing what would have been a default in prior cycles as sponsors underwrote more cov-light loans to win business. This is hard to assess given the non-public nature of the borrowers and the funds. We may see glimpses in sponsor-reported financial statements/sec filings.
  • Our view is the economy has been enduring a rolling-recession, hitting different sectors at different times, which has allowed many companies to weather the weakness better than most would expect. Significant deteriorations in sectors such as retailers may indicate the pain to come.
  • Many companies have been able to deal with the initial spike in interest rates, however, will they be able to weather higher-for-longer? Decreases in companies free cash flow (“FCF”) due to slower economic growth and higher interest rates may not be sufficient to service debt over the medium term.
  • A slowdown in continuation vehicles (vehicles set up to facilitate holding assets/companies in a private vehicle as an alternate to a ‘natural’ exit via either an IPO or being acquired). So far, YTD, more continuation vehicles are being launched, so this may take a while to play out.
  • Banks start to become more competitive, competing with private credit for the same loans, driving down returns as participants compete on price. At a recent private equity conference hosted by the Markets Group, a private credit participant noted there was some competition from traditional banks, that had beaten them out on business by offering rates roughly 30 bps below what private credit could underwrite the loan at.

It might be a touch too early to call for a meaningful pullback in private credit. Regardless, before you invest in any asset class you should always ask yourself:

  • What does the market see and what does it not see?
  • Where is the opportunity?
  • Where is the downside?
  • What is the best way to invest – if any?

Private credit is definitely the cool kid on the block these days and is experiencing some kind of inflection in the market, although it is definitely binary in direction.

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