If you believe the critics, the private credit bubble is bound to burst any day now. However, for institutional investors, the asset class still tells a story that seems too good to be true.
Despite its illiquidity, private credit offers attractive returns and relatively low volatility. With interest rates at their highest levels in more than a decade, the asset class’s yield has become more enticing.
Right now is a time where opportunities and challenges co-exist in private credit, at least in the Australian market, ICG head of Australian senior debt Matthew Turner told the Investment Magazine Private Credit Forum.
Higher rates are certainly good news, and the future deal environment is also looking healthy, he said.
“Higher base rates means that your total returns should remain higher for longer on a gross basis,” Turner said.
“There’ll be lower leverage in deals going forward just by the fact that the cash flows are constrained by the higher base rates.
“As we get more funds into this market, there’ll be larger market deals, and that will be because there’s more capital to go around and provide [for them]. We’ve got more international PE funds coming here, so we’ve got a chance to do bigger and better deals for bigger and better companies.”
However, there are also a few risks at play for the asset class, and Turner said the market might be focused on the wrong thing.
“Everyone talks about interest rates, interest rates, and interest rates, but they are extraordinarily boring compared to what’s actually happening with labour inflation,” he said.
“If you want to go and sit there and have a look at what is going on in portfolio companies across all of Australian credit, labour cost is the number one concern.
“One thing I’ll tell you is the healthcare sector is no longer as defensive as it once was. We have seen the most extreme labour price inflation, there is a lack of supply of medical professionals that cannot be actually brought to market in any time soon.”
Deals in the Australian market are also running on higher leverage than they historically have as the nation moves from a low-interest environment. This reality would pose challenges to portfolio companies, Turner said, but he said he is confident about private credit’s resilience.
“What I would say…is this hurts equity way more than it hurts debt. We have generally a 50 per cent embedded subordination in our deals from a capital perspective, so they [portfolio companies] have to pay their interest bills first. If they don’t do that, they’ll make their business at risk,” he said.
“What tends to happen is they will ration their cash in other parts and how they run their business.”
Net Zero landscape
Apart from macroeconomic factors, private credit investors are also grappling with their strengths and limitations in key thematics such as net-zero transition finance.
Opportunity-wise, IFM Investors associate director of debt investments Matthew Cohen said a diversified asset manager is in a prime position to facilitate a broader discussion of transition finance.
“We think about the sort of economic activities that happen in the wide-open spaces, and there are transition opportunities that exist outside of that pure power generation segment,” he said, suggesting areas including real estate, transport and real estate.
“We pay very close attention from investment diligence to how we manage portfolios, and then how we set investment strategies and the investment lifecycle. That all feeds into informed capital allocation.
“As private credit managers, we love risk mitigation…and a big part of that is managing transition risk and managing climate risks.”
However, while debt investors intend to play a bigger facilitation role in the net-zero transition, a big challenge is that their voice is weakened in the boardroom, Cohen said.
“We don’t have board seats. Depending on the type of transaction, we can be one of 10 or 20 lenders, so your scope to have influence to compel investee companies to transition is diluted somewhat,” he said.
“As a debt investor, your investment horizon is three to five years, maybe slightly longer for certain sectors. But what sorts of transition can you compel over that timeframe to still fit within investment objectives and considerations?”
In these conversations, the key for debt investors is to both have a balanced approach and investment expectations, Cohen said.
“The utopia for us is that we can execute on investment strategy and get paid commensurate rates of return relative to the credit risk and sustainability risk,” he said.
“Having an investment investor base that is very informed and understands the practicalities of these challenges and understands what that means for investment strategy [is important].”
Synthetic risk transfer
The global private credit is now estimated to be worth US$2.1 trillion (3.2 trillion) and about three quarters of that lies within the US market, according to the International Monetary Fund (IMF). And within this huge market, asset manager the D. E. Shaw group has spotted opportunities in synthetic risk transfers (SRTs) amid banks’ search for capital relief.
The strategy is sometimes referred to as significant risk transfer, regulatory capital trades or credit risk transfer. SRTs allow banks to essentially transfer the underlying risk of their exposures, such as a book of corporate loans, to investors, but retain that exposure on their balance sheet.
The group’s New York-based head of private credit investments Marianna Fassinotti said the strategy has seen some favourable regulatory developments in the US recently, after the Federal Reserve clarified how SRTs may relate to its capital rules. This could jumpstart the growth of assets and the number of securitisation issuers, she said, and the potential increase is substantial.
“This [SRTs] was really a technology that was adopted much earlier by European banks than by US banks,” she said.
“There have been transactions in the US for five or six years, but in earnest, it’s just beginning in the US today.
“If every large bank globally issued as much regulatory capital relief as part of their risk weighted asset planning as the top five banks that exist today that are doing this, you would see about 250 per cent increase in the issuance of synthetic risk transfer notes.
“I’m not saying that that’s what’s going to happen, but the penetration of the technology at banks both in the US and more generally is still pretty low.”
For asset owners looking to jump onto the bandwagon now, Fassinotti said they can expect desirable traits including high-yield return profiles, exposure to “core” banking assets, floating-rate instruments, and alignment with issuing banks.
“Looking forward, we definitely think that consumer finance will continue to be an asset class that gets folded into more synthetic risk transfer issuance,” she said.
“The public credit markets and even the private credit markets, specifically direct lending, don’t usually intermediate the assets that the banks are using to achieve regulatory capital relief.
“These are not loans that the bank is looking to sell or move off balance sheet from a relationship perspective.
“So this [SRTs] is the tool to get access to that level of credit exposure.”
The Asia opportunity
Some other asset managers, meanwhile, have set their eyes on the budding private credit scene in Asia, even though Asia Pacific’s private credit market only stood at US$81 billion as of 2021 and somewhat dwarfed by North America and Europe.
“What’s been incredible over the last five to 10 years in particular, is the amount of capital that has gone into support larger and larger businesses [in Asia Pacific],” said Ares Asia head of sponsor direct lending Peter Graf.
“In India, of the 25 big global private equity firms, almost all, if not all of them, have been active in the country for 10-plus years already.
“If you look at pricing as a whole that’s on offer on private credit in Asia…most of the time, you’re getting a premium. That could be 75 basis points to 100 basis points on developed market risk, and then on emerging market risk, it could be 200 basis points plus.
“The real opportunity over the next 20 to 30 years is Asia.”
From an asset owner perspective, Future Fund director of credit Shikha Gupta said the $272 billion sovereign fund has a healthy appetite for private credit.
Over the years, the fund’s strategy has shifted from real estate-backed lending and distressed lending to performing credit more recently in emerging markets.
“Quite frankly, it makes me sleep better at night,” Gupta said of the pivot.
“I think these [emerging] regions…are all maturing.
“For us, the important thing is making sure we are getting a premium for it and making sure it stacks up on a relative value basis versus everything else that we’re seeing globally.”
With that said, Graf warned of the risk that lies in a “fly-in fly-out” approach to investing in Asia debt.
“You need to be on the ground living and breathing the credit, the culture and the country to really understand what’s going on and what your protections are if things don’t go well,” he said.
Gupta echoed the sentiment and reiterated the consequent importance of sourcing in Asia.
“It’s a very different type of sourcing – it tends to be more proprietary in places like India… you don’t have a broker calling all the private credit managers, so you really need to know the person intermediating the deal,” she said.
“So really strong sourcing capability that is tailored to the individual markets is important.”
Real estate play
Meanwhile, many investors have turned to real estate in search of downside protection within private credit.
Speaking of the US market specifically, alternatives asset manager Kayne Anderson’s real estate chief investment officer David Selznick said there will be plenty of opportunities for private credit investors to buy loans from regional banks.
Close to half of the US real estate banking system is made up of regional banks, Selznick said, and after interest rates jumped, their “underlying loan covenants are being busted”.
“You have all these banks that were supporting the real estate market in the US that are now on the sidelines, and there is a huge opportunity to fill that gap with private credit,” he said.
However, Selznick also stressed that the process won’t be easy and is like to be a “tactical game”, since many of the regional banks still have a wait-and-see mindset and aren’t willing to sell their loans at a discount or an attract level for a buyer.
“But I will tell you, this higher-for-longer situation that we have is now forcing decision making. It’s starting to become a reality that interest rates are not going to save these banks,” he said.
“[Buying the loans] is relationship-oriented. None of these banks are going to be broadly marketing their portfolios, because they don’t want to air their dirty laundry.
“Bankers are very proud people, so they have a hard time admitting that their portfolio might be impaired in some degree.
“Any of the bank failures, like Signature Bank, those obviously get marketed widely, and the big guys like Blackstone or Brookfield will compete on buying the big portfolios. We actually think there’s way more value in the US$250 million to US$2 billion portfolio range with these [other regional] banks.
“But again, it’s a ground game,” he said.
All photo credit to Jack Smith.
