As interest rates on investment grade bonds have fallen to near-zero, private credit has attracted increased interest from institutional investors. Callan expects that private credit, one of the newest asset classes within alternative investments, will offer substantially higher yields and equity-like total returns while in some cases providing regular cash distributions. In exchange, investors must accept illiquidity, with individual loans having an average life of three to five years and fund terms typically ranging from five to ten years. Additionally, private credit potentially incurs higher credit risk as borrowers are often smaller than those able to access traditional credit markets.
The size of the private credit market is estimated at approximately $2 trillion, and it is growing swiftly. Bank of America Merrill Lynch estimates that private credit accounts for about 17% of total credit today and that it has increased by 14% per year since 2000, about twice the rate of public credit. Private credit growth accelerated after the Global Financial Crisis (2007-09), as banks exited or pulled back from many areas of lending.
Three Key Categories
Callan brackets private credit into three broad categories based on their risk and return components: core, opportunistic, and niche.
Core strategies are broadly diversified by industry, with current income the primary driver of returns. Credit losses are expected to be very low.
- Direct Lending (6%-8% unlevered returns): Origination or purchase of commercial loans used to finance general business operations, projects, or growth; often bilateral (single lender and borrower) or may involve a small group of lenders, as distinct from broadly syndicated loans
- Mezzanine Lending (8%-10% unlevered returns): Origination or purchase of commercial loans used to finance general business operations, projects, or growth but lower in the capital structure than direct lending
- Structured Credit (6%-10% unlevered returns): Diversified pools of corporate and asset-backed loans with cash flows segregated into different credit tranches
- Real Assets Lending (5%-7% unlevered returns): Origination or purchase of loans backed by core real assets, including real estate and infrastructure
Either more sensitive to credit cycles than core strategies, or broadly diversified across markets; outsized returns created by managers opportunistically rotating across sectors
- Distressed Debt/Special Situations (10%-15% unlevered returns): Invests across the capital structure in stressed or distressed companies, often involving restructuring
- Multi-Sector (8%-12% unlevered returns): Diversified approach across private credit subcategories, with allocations potentially changing opportunistically over time; requires deep resources across multiple credit sectors and geographies
Concentrated in a single industry or non-U.S. geography, or involving a more esoteric structure or form of collateral
- Specialty Finance (8%-12% unlevered returns): Lending to non-traditional borrowers, including rediscounting (lending to lenders), transportation (e.g., aviation, shipping), consumer loans, and litigation finance
- Royalties (8%-12% unlevered returns): Lending or structured equity relating to intellectual property (patents, trademarks, etc.) or cash-flow producing pharmaceutical assets
Private Credit Trends in the Recent Dislocation
In 2020, significant public market dislocations occurred in the first part of the year because of the pandemic, only to bounce back due to the injection of capital through significant government stimulus packages. This rebound, however, was not uniform across all asset classes, with pockets of both public and private credit experiencing slower recoveries. Riskier credits, particularly those with stressed balance sheets and/or significant exposures to COVID-affected industries such as lodging, leisure, and travel, have sought liquidity solutions. Many of these solutions have been provided across a myriad of private credit strategies including opportunistic lending, distressed/special situations investing, and multi-strategy approaches.
Many private credit managers are well-poised to generate outsized returns as the dislocation extends into 2021. Strong sourcing, disciplined underwriting, and deep restructuring capabilities are traits sought in top-performing managers. Here are some key themes in the private credit universe:
Sponsor-driven direct lending: underwriting standards deteriorated leading up to the dislocation—time for a reset
Covenant-lite and covenant-loose issuance became more prevalent late in the credit cycle, which was more borrower-friendly to the detriment of limited partners. EBITDA adjustments were at all-time highs, fundamentally changing the leverage metrics over the expected life of loans. Average leverage multiples for middle-market loans jumped between 2009 and 2019 from 3.4x to 5.6x.
Business development corporations and collateralized loan obligations became a material consumer of private loans and are seeing an increase in CCC credits, as well as limits on their ability to attain portfolio-level leverage financing. These structures may lead to forced selling of troubled loans in the current dislocation.
Over the course of 2020, direct lending portfolios saw a material increase in stressed/distressed assets; as a result, liquidity was shored up through rescue loans; additional equity infusions from PE sponsors; and the restructuring of loan terms, including interest payment holidays.
New deals have been structured with tighter covenant structures, lower leverage, and lender-friendly terms relative to those at the top of the cycle. Premium pricing for new originations continued through year end but did start to compress, from 300-500 bps to 100-200 bps or less, particularly in less COVID-impacted sectors such as health care, technology, and business services.
Callan is favorable on managers that entered the current dislocation with credit discipline, stable teams with down-cycle experience, strong sponsor relationships, and deep work-out capabilities. The stronger lenders in this space will be best equipped to cherry-pick loans in a growing secondary market fueled by forced sellers.
Finally, opportunistic lenders with the flexibility to execute quickly around complex deals and across both sponsor and non-sponsor opportunities have the proven ability to extract excess spread above traditional middle market lenders and are well positioned to outperform during a dislocation in which liquidity is priced at a premium.
Distressed investing: cycle may be muted but pockets of opportunity exist
A significant late-cycle distressed capital raise took place over the last few years, often in the form of trigger or contingent capital structures. This brings us to the current dislocation, now estimated to be a $1 trillion-plus opportunity. Trigger funds that have been activated, combined with additional capital raised during the current dislocation, has created over $200 billion in dry powder.
Corporate default rates were benign over the past several years but, given the pandemic’s impact on a number of sectors, they were initially expected to ramp up to 10%-15% over the next two to three years, creating a robust distressed investing opportunity. But the re-opening of the new issuer markets, recent government stimulus, and a robust pool of capital raised and targeted at providing companies with liquidity solutions is expected to somewhat mute the traditional corporate distressed opportunity. Current estimates for U.S. corporate default rates are in line with the historical average of 4%-5%.
In navigating the chunky distressed opportunity set, Callan expects that distressed and opportunistic strategies with creative and wide sourcing channels and deep investment teams across geographies and sub-strategies, including structured credit and real assets lending, should be best positioned to drive strong returns through the current part of the cycle.
Niche private credit: compelling returns can be accessed by strategy, and manager selection is key
The later stages of the credit cycle saw increased investor demand for higher-yielding niche credit strategies such as specialty lending, litigation finance, and royalty strategies. These niche strategies can be accessed both through stand-alone specialized funds or as a sleeve within a broader multi-strategy fund.
Many of these strategies can benefit a broader portfolio by adding diversification through low market correlations as well as, in some cases, cash income. Unique industry expertise and the ability to structure complex deals can drive premium returns.
In the recent dislocation, it is important to re-underwrite these niche investments, focusing on relative value, the true level of diversification, and the ability of investment teams to navigate any stress in underlying portfolio investments.
New niche opportunities may emerge; manager and strategy selection will be extremely important in building out these diversifying exposures.