Active Management Comes for Private Credit
Private credit was once the wild frontier of finance. An outgrowth of prior booms in junk bonds, leveraged buyouts, and private equity, private credit evolved as a niche of nonbank lenders providing privately negotiated, floating-rate loans to highly leveraged companies.
Then, the global financial crisis (GFC) set off a rare confluence of forces that accelerated private credit’s growth. Massive government fiscal stimulus, near-zero interest rates, stricter bank regulations, and a surge of capital in search of yield combined to encourage aggressive lending outside of the traditional banking system. Investors rushed in, chasing outsized returns.
But like all frontiers, corporate direct lending has grown more crowded and less differentiated over time. The era of “easy money” has faded as interest rates have risen. We believe the flood of investor capital in response to strong historical returns has caught up with available opportunities.
Corporate direct lending, still the largest private credit sector, now looks much more like the broadly accessible syndicated bank loan market and less like the relatively exclusive, outsized return opportunity it was perceived to be years ago – yet it still carries higher fees, less liquidity, and fewer exit ramps for investors. In our view, the old private credit playbook of the post-GFC era, based mainly on providing access to corporate direct lending via semi-liquid vehicles, no longer feels sufficient.
The real story in private credit today is the shift from access to active management. We believe the new playbook is about unlocking potential opportunities through active, relative value strategies – comparing risk and reward across subsectors, and even across entire markets, and allocating capital accordingly.
Opportunities have expanded
In today’s environment – as banks adjust to higher rates, evolving regulations, and real estate strains – private credit has blossomed beyond corporate lending into a sprawling ecosystem touching nearly every corner of the economy. Private credit markets are now large and diverse enough to offer a spectrum of risk profiles and valuations and encourage relative value strategies.
Areas of growth include asset-based finance, which provides funding across the global economy through residential mortgage credit, consumer credit, and non-consumer lending, often secured by hard assets as collateral. Real estate lending is another increasingly dynamic area.
We believe a relative value approach is even more important at a time of rising interplay between publicly traded and private credit, evident in the overlap of asset types available in each market, fund-flow dynamics, and growing interest in trading platforms for private assets.
A limited, zero-sum view of this interplay is that private credit may stand to steal share from public credit markets. We take a more expansive view. More than ever, investors can now pick and choose across the credit spectrum to find investments that they believe offer the best risk-adjusted return potential.
A more versatile toolkit
Today, we find that public and private markets are not rivals, but rather complementary tools in an investor’s toolkit. Investment managers who operate solely in either public or private markets tend to promote only their own approach. By contrast, active managers with access to both markets can offer unbiased views and pursue opportunities based on their relative attractiveness at any given time.
Where are the potential opportunities today? We believe asset-based finance stands out, as do some areas of real estate lending. We favor a mix of fixed- and floating-rate assets. We find higher-quality, private, consumer-related credit to be more attractive than most forms of corporate credit, due to a combination of stronger lending standards, lower starting leverage levels, and favorable valuations.
In our view, the days of passive exposure to the market’s wild frontier are over. Now, in a more mature and complex market, it’s about being discerning and nimble. Applying an eye for value and time-tested active management strategies can help unlock private credit’s full potential.
(For more, please read “Active Management Comes for Private Credit: In-Depth Investment Approaches”)
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Disclosures
All investments contain risk and may lose value. Investments in asset-based lending and asset-backed instruments are subject to a variety of risks that may adversely affect the performance and value of the investment. These risks include, but are not limited to, credit risk, liquidity risk, interest rate risk, operational risk, structural risk, sponsor risk, monoline wrapper risk, and other legal risks. Asset-backed securities across various asset classes may not achieve business objectives or generate returns, and their performance can be significantly impacted by fluctuations in interest rates. Investments in residential/commercial mortgage loans and commercial real estate debt are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks and adverse regulatory developments, which risks may be heightened in the case of nonperforming loans. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Investments in mortgage and asset-backed securities are highly complex instruments that may be sensitive to changes in interest rates and subject to early repayment risk. Structured products such as collateralized debt obligations are also highly complex instruments, typically involving a high degree of risk; use of these instruments may involve derivative instruments that could lose more than the principal amount invested. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. Investing in distressed loans and bankrupt companies is speculative, and the repayment of default obligations contains significant uncertainties. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Diversification does not ensure against loss.
There can be no assurance that the trends mentioned will continue. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
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