Private Credit: Playing A Critical Role In The Global Economy

For anyone doubting the importance of Private Credit to the global economy need look no further than the events of 2008. This period is universally considered the worst financial crisis since the Great Depression of the 1930s.

In a single day, publicly traded stocks fell over 777 points in the face of investor panic. At the height of the crisis, public debt markets were virtually frozen. Two Wall Street giants, Bear Stearns and Lehman Brothers became insolvent.

A little further down Wall Street, giant Goldman Sachs was facing a similar fate. Failure of yet another major financial institution held ominous implications for virtually everyone on the planet. It was at this point that billionaire investor Warren Buffett stepped in offering an emergency loan amounting to $5 billion.

In return Buffett demanded an interest rate of 10% and the right to convert his loan to preferred shares of Goldman Sachs. This loan prevented financial implosion and provided the necessary time for the Federal Reserve to devise its so called rescue plan: TARP. According to Bloomberg News, Mr. Buffett pocketed a profit of approximately $3.7 billion for a 74% return.

Perhaps more than any other single transaction Warren Buffett’s private loan to Goldman ignited a wave of demand for private credit that continues today.

Private Credit Under The Microscope

Private credit often shines brightest when public markets are out of balance. A stock market correction wipes out a big share of your assets just as your company needs to invest in new machinery in order to stay competitive. You lose your job just when your home needs repairs and your credit cards are maxed out. This is the time when having access to private credit can be a life savior.

Typically, private credit is extended to companies and individuals with the later representing the fastest growing part of the business. As the name implies PCs are not publicly traded. Rather they are originated and held by lenders other than banks. PCs take various legal forms including loans, bonds, notes or private securitisation issues.

Private credit encompasses various strategies including real estate debt, distressed debt, direct lending, mezzanine financing and structured financing. Interest rates are set on a strictly negotiated basis often times at more favorable level than consumer credit cards.

Direct Lending Stands Out

Within the Private Credit space, the rapid rise in direct lending funds has been notable. In the recent Preqin report, direct lending accounted for the second largest share at 30% and is rapidly taking over the number one spot.

Direct lenders have received a particularly strong tailwind as traditional bank lenders have cut back on business lending in the post-crisis regulatory landscape.

While direct lending has taken center stage, traditional strategies such as distressed debt, special situations and mezzanine lending continue, but at more moderate rates. This trend was evident in this years first quarter when 19 private debt funds raised $14 billion of new funds compared with $25 billion for the same period of 2017.

How Direct Lending Works

Direct lending is simply old-fashioned bank lending, just without the bank. It all started with asset managers like Oaktree Capital. That meant mostly hedge funds and private-equity funds, but now includes other types of investors as well, including insurance firms raising pools of money from investors interested in debt.

Managers field pitches from debt advisers with investment opportunities. Sometimes this even includes private-equity funds looking to finance acquisitions. The direct-lending fund does its own research before deploying its money. Direct lenders tend to hold onto the loans long-term, sometimes offering growth support to the company and entering into multiple funding rounds, although some funds do sell a small proportion of their debt.

What Is Causing The Boom In Direct Lending

With names like Lending Tree and LowerMyBills.com, to name just a few, consumers have become quite familiar with the business of direct lending. And for good reason. US households are straddled with over $1 trillion in installment debt mostly through Visa and MasterCard. The average American has credit card debt of more than $6300 and a credit score of somewhere between 650–685. That usually translates into interest rates on those cards of 18% to as much as 28%,

LendingTree and other direct lenders compete effective by employing credit scoring algorithms that more accurately measure true credit default risk. The result is lower rates and lower monthly payments for the borrower: a winning combination.

Related: Gareth Henry Discusses Hedge Funds vs. the Traditional Equity/Bond Investing

Institutional Investor Appetite for Credit Is Growing

Institutional investors, more specifically, pension funds, have been increasing allocations to private credit given the low-return environment traditional fixed income products. Private debt assets under management reached $667 billion in 2017, up 13% from the previous year according to a report from Preqin.

The report also noted that during the second quarter of 2018, 22 private debt funds closed, securing an aggregate $25 billion, an increase of $5.3 billion over first-quarter fundraising and $600 million over the second quarter of 2017.

Caveat Emptor: Illiquid Asset Returns

As a result of the significant variation in underlying strategies, terms, structure and liquidity, the risk and return expectations vary widely across private credit strategies. In addition, investing in Private Credit involves assets that are illiquid and cannot be sold immediately without a potentially significant impact on price.

For this investors typically require incremental yield. It is sometimes called an illiquidity premium. However, according to fixed income giant PIMCO it is not easy to precisely calibrate what level premium an investor ought to demand as compensation for tying up their capital.

Simply comparing yields or credit spreads is appropriate if the underlying debt has similar credit and other risks. However, that is rarely the case; and even where credit metrics are comparable, underlying credit risk may still be quite different. In PIMCO’s view:

“It is therefore essential for investors to adjust for the underlying credit risk or anticipated losses when comparing prospective returns from both more and less liquid forms of credit risk.”

Who Has Delivered Performance

In the absence of measurable returns, the challenge becomes what metrics to apply in separating the winning funds from the rest of the pack. One way is to follow the money into those funds with the largest exposure to direct lending. That assumes that investors are allocating funds to the area providing some consistency of above average returns.

A somewhat different approach suggests that those funds that are the largest have also provided a level of consistent performance that has both satisfied existing investors and added new ones.

The link below provided a guide to this group of large funds authored by Institutional Investor Magazine.

For more insight from Gareth Henry, connect on LinkedIn, Facebook or visit his website: garethhenry.com