Like private equity, private credit focuses on opportunities outside the public markets, but deploys its capital in the form of credit rather than taking equity stakes in businesses. It includes a range of strategies, including direct lending for leveraged buyouts and lending to distressed businesses.
Despite its lower profile, private credit is, in some countries, growing even faster than private equity. The Financial Times recently called it “the investment industry’s hottest neighbourhood”. (1) But, as regular readers of this blog will know, the fact that an asset class is hot is often a very good reason for not including it in your portfolio.
So is now a good time to be investing in private credit? Well, let’s start with some historical background.
Private equity firms taking over from banks
Traditionally, it was banks that lent money. But since the mid-1990s, lending has increasingly been done by private companies. This trend accelerated in the wake of the global financial crisis, when financial regulators tightened restrictions and capital requirements on banks.
As banks cut back their lending activity, corporate borrowers looked to non-bank lenders to finance debt instead. Today the market is dominated by large private equity firms like Apollo Global, Blackstone and Carlyle Group. And although private credit was once the preserve of institutional investors and very wealthy individuals, firms are increasingly looking to raise money from ordinary retail investors.
According to the data provider Preqin, the global private debt market reached $1.5 trillion by the end of 2022.
The benefits of private credit
There is no denying that, as an asset class, private credit has its attractions in the current climate, offering as it does high yields and protection against inflation. Although there is relatively little academic research available, studies suggest it has a strong risk-and-return-return profile compared to other, more traditional, fixed-income investments, such as investment-grade and high-yield bonds. Private credit also offers investors a way to diversify their portfolio.
Another benefit of private credit that has been suggested is that, unlike other areas of asset management, past performance does provide a reasonable clue as to future performance. In other words, fund managers — or General Partners as they’re known — with good past performance often go on to replicate it.
The risks of private credit
But private credit comes with risks as well. The most obvious risk is that, as with equities, private credit returns are dependent on a company’s success. If the company is unsuccessful, it may default on the loan.
Something else to bear in mind is that companies which seek out private credit have, in many cases, been denied lending by a bank or credit union. In other words, they’re likely to have a weaker credit profile and are therefore at higher risk of default.
Remember as well that, as an investor in a private credit fund, your returns depend on the skill and expertise of the fund’s General Partners. Research by Pascal Böni and Sophie Manigart published in the Financial Analysts Journal has shown different funds provide a wide range of outcomes, with only a small group of top-performing funds. (2)
Another big downside is illiquidity. Private credit is a highly illiquid asset class and is only suitable for investors with a long time horizon. If you want or need to sell within a few years, you may well struggle to do so — at least without incurring significant losses.
A final risk to consider is that the private credit industry has lower underwriting standards than banks and other traditional lenders. These standards are designed to protect lenders, so again, lower standards mean higher risk for investors.
Challenging times ahead?
So are there any reasons to be particularly wary of investing in private credit now? Well, there might be. Twice in recent months, respected financial organisations have published papers suggesting that current market and economic conditions have made it less attractive.
In April S&P Dow Jones Indices released a paper called Private Lending: Time to Adjust the Sails in which it warned there may be challenging times ahead. (3) The report said: “The factors that have steadied borrowers — strong cash balances, long-dated maturity walls and a resilient consumer base — are starting to erode… The pressures on traditional direct lending must also be significant as margins are thinner and leverage is higher.”
Another report, in June, by the ratings agency Moody’s warned that investors in private credit should brace themselves for lower returns. (4)
“The stage is set for the first test of private credit,” the authors warned, “with factors underlying the market's exceptional growth and strong performance having changed dramatically in recent quarters. Now rates are rising, economic growth is stalling and there is less capital flowing into risk assets.
“With monetary policy tightening, economic growth stalling and less capital flowing into risk assets, there are likely to be rising defaults among private credit borrowers.”
Don’t be complacent
It’s not surprising that private credit has become so popular. In a long period of very low interest rates, investors have inevitably looked for higher, but stable, returns.
It’s a strategy that, generally, has so far paid off. But no investment is free from risk, and just because we haven’t yet seen defaults in the private credit market, that doesn’t mean they won’t happen in future.
We shouldn’t be surprised to see some volatility either. Because the growth of private credit is a relatively recent phenomenon, the lived experience of investors is that returns are steady and smooth. But that won’t last indefinitely.
So don’t be complacent about the risks of private credit. Things can stay the same in the financial markets for a very long time, lulling investors into a false sense of security, and then suddenly change.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.
References:
- https://www.ft.com/content/42297b43-7918-4734-b6d5-623c6d6fa00f
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3932484
- https://www.spglobal.com/en/research-insights/featured/special-editorial/look-forward/private-lending-time-to-adjust-the-sails
- https://www.moodys.com/research/Financial-Stability-Cross-Region-Private-credit-performance-will-ebb-as-Sector-In-Depth--PBC_1370285
