Active Management Comes for Private Credit: In-Depth Investment Approaches

Since then, semi-liquid real estate strategies, as well as evergreen, core-focused real estate vehicles, have experienced more redemption pressure. Although this hasn’t led to widespread forced selling to date, the transition has affected the technical backdrop in real estate markets, and persistent outflows could create motivated selling activity over time. 

Volatility in public markets has highlighted the perceived stability of private credit. However, this stability often comes with a trade-off: Lending terms may be less favorable than those in public markets, and the much-touted “certainty of execution” tends to benefit borrowers more than investors.

The pathways to secondary transactions in private credit are also expanding (see Figure 2). What began as a niche focused on secondary fund sales and transfers of limited partner interests – ownership stakes in private credit funds – is evolving into a broader marketplace that includes fund finance, risk transfer tools, and portfolio and single-asset sales. We expect these trends to persist, offering new opportunities for relative value.

Rather than creating a competition between public and private credit, this market intersection is giving investors a broader set of tools. The real challenge is not choosing one market over the other, but navigating an expanding array of structures, sectors, and technical factors to find the optimal balance of risk and return.

Sector and asset selection

Despite this growing interplay between markets, private credit still stands out when it comes to investment strategy types and investor preferences.

In public fixed income, the largest fund categories typically use flexible approaches that span multiple sectors instead of focusing on just one. In higher-quality core fixed income, flexible strategies are more common than those targeting only investment grade (IG) corporate bonds or mortgages. Similarly, in higher-yielding categories, multi-sector funds outnumber those focused on specific areas such as high yield or bank loans.

By contrast, the private credit fund landscape has largely favored sector-specific strategies (see Figure 3).

Flexible, actively managed funds are well-positioned to look across different sectors and invest based on relative value rather than following rigid mandates. We see an increasing, largely untapped opportunity in private markets to extract value and enhance risk-adjusted returns through diversification, sector allocation, and asset selection – an approach PIMCO has honed for more than 50 years.

Public credit investors generally wouldn’t place nearly all of their allocation in the bank loan market. Similarly, private credit investors shouldn’t rely solely on corporate direct lending. Instead, investors should use diversification as a tool to navigate cycles. We believe diversification has never been more achievable than it is today, as higher interest rates and bank retrenchment open scalable opportunities in private asset classes beyond corporate credit.

Just as in public markets, private credit investors can emphasize or de-emphasize subsectors according to the most attractive overall compensation for risk. This can be based on sector allocations (e.g., corporate, asset-based, real estate) or a granular focus on subsectors offering the most attractive risk/reward profile. This often requires careful application of data and analytical models – akin to option-adjusted frameworks in fixed income – to assess specific differences and derive an overall measure of risk compensation.

Starting conditions and valuations can differ significantly across sectors. In corporate lending, leverage levels are elevated versus historical norms. In asset-based finance, valuations and deal structures appear more attractive. Meanwhile, real estate markets are recovering from a challenging cycle.

Today, we find higher-quality, private, consumer-related credit is far more attractive than most forms of corporate credit, due to a combination of stronger lending standards, lower starting leverage levels, and favorable valuations.

Structural alpha

We also see structural alpha playing a growing role in private credit. This concept involves identifying repeatable structural inefficiencies in markets – e.g., decisions made by noneconomic investors such as insurance companies, whose primary objectives often emphasize net investment income versus total return – and creating a diversified portfolio of these inefficiencies, allowing investors to capitalize on value dislocations.

As private credit has matured, it now features a more formal market structure, with a wider range of participants, investment vehicles, risk-transfer mechanisms, and regulatory oversight. We see four increasingly relevant sources of structural alpha:

1. Preferred habitat: This is a theory typically applied to the bond market, focusing on investor preference for bonds based on their term structure. For example, some investors who favor short-duration bonds will do so almost regardless of relative value versus longer-duration investments. An analog in private markets would be that many investors continue to focus on floating-rate credit as a means to reduce mark-to-market sensitivity to interest rate changes. This in turn creates much less crowding in opportunities within fixed-rate, or longer-duration, private credit. Aviation finance is an example of an area that falls outside of the preferred habitat of many private credit investors, which can result in more attractive risk-adjusted return profiles.


2. Noneconomic participants: We have seen increasing private market activity from noneconomic buyers from multiple vantage points:
   • Evergreen fund flows: In public markets, flows into and out of passive funds can drive structural alpha. In private markets, inflows have fueled significant growth in relatively narrow, evergreen private strategies such as BDCs and REITs. These vehicles, which tend to be more beta-focused, may need to deploy capital quickly and can be subject to monthly or quarterly redemptions, creating market distortions. Recently, BDCs have contributed to narrower direct lending spreads and elevated redemption activity in evergreen real estate vehicles. This has allowed PIMCO to source triple net lease real estate assets with long-term leases to well-known corporate tenants at attractive spreads relative to similar unsecured corporate credit risk.
   • Insurance capital: Insurance demand for private credit has surged over the past decade, driven by a focus on capital efficiency – either through assets with favorable credit ratings or those that receive preferential regulatory treatment. This influx has led to significant spread compression in assets prized for their capital efficiency, such as IG private credit and fixed-rate commercial mortgage loans, often making their pricing or terms less attractive versus more liquid market alternatives. PIMCO has capitalized on this strong bid for private IG credit by obtaining attractive senior financing on complex asset-based portfolios.
   • Bank risk disposition: Banks typically want the client relationship that accompanies loan origination, but regulations and risk management often incentivize banks to dispose of the asset. The result has been a variety of portfolio sales, forward flow arrangements, and risk transfer transactions. The common theme: a market participant motivated to offload risk for reasons other than maximizing value. PIMCO has benefited from this trend by investing in mortgage and consumer portfolios from banks, while also stepping into flow arrangements with platforms seeking capital partners.


3. Ratings: The growth of private credit has contributed to the rise of private IG credit assets. The implications of this trend are twofold:
   • Security selection within IG markets: We often observe private credit investments that carry an IG rating from one rating agency but do not have the characteristics investors expect from IG credit. Such differences can be due to repayment priority, deal structure complexity, or borrower credit quality. These issues often mean inferior compensation compared with similar investment opportunities.
   • Financing opportunities in private credit: Robust demand for private credit with an IG rating allows active managers to extract additional value by structuring deals to optimize for a rating agency rating, thus benefiting from attractive financing. This requires deep expertise in structured credit, rating agency methodologies, and capital structure relative value analysis. Given growing demand for private credit among insurance companies (see Figure 4) and other investors seeking the perceived safety of an IG rating, we expect this trend to continue.

4. Behavioral finance: Much of the enthusiasm for private credit stems from its strong run during the relatively unprecedented investment environment of the past 15 years. But clinging to a backward-looking strategy that leans heavily on lower-quality, floating-rate and structurally leveraged credit is dangerous in today’s higher-rate world. Success now demands a balanced mix of fixed- and floating-rate assets, a willingness to embrace longer durations, and a focus on relative value across credit sectors. Simply put, yesterday’s approach won’t cut it in tomorrow’s market.

Conclusion

As private credit matures, it is no longer defined by the pursuit of access or the novelty of alternative lending. Today, it represents a multi-faceted arena offering exposure to diverse borrower profiles and deal structures. The blurring lines between public and private markets, the proliferation of asset types, and the growing influence of technical and structural factors have created a landscape rich with opportunity.

Success in this new era will depend less on being early and more on being discerning. Investors must be able to assess relative value, understand the nuances of different vehicles and structures, and respond nimbly to shifting market dynamics. The toolkit for pursuing returns is larger than ever, but so too is the need for rigorous analysis and active management.

Ultimately, private credit’s coming of age will most likely favor investors who combine flexibility, discipline, and a keen eye for value. Those who can look beyond headline yields and embrace a more nuanced, strategic approach should be well-positioned to capture the market’s rewards.