Private credit: when money isn’t free anymore

Key points

• With central banks hiking interest rates and economic growth uncertain, many companies are finding it hard to access credit from traditional sources – just when they need it most
• Private credit markets can offer solutions to help companies obtain the borrowings needed – and in structures that can be tailored to their needs
• For investors, private credit markets offer a range of strategies, as well as the chance to further diversify their portfolios

• While it can offer attractive returns, private credit markets are not for everyone – and there are risks that need to be understood before you invest in the asset class

In the face of an economic slowdown and rising rates, companies are finding it tougher to access traditional sources of funding. Private credit can fill the gap and help provide borrowers access to a more transparent source of debt, while offering investors the chance to diversify portfolios and potentially boost returns for little extra risk.

With central banks racing to hike interest rates, the era of “free money” we’ve grown used to in the last 10 years has come to an end. To illustrate this point, the global aggregate market value of negative yielding debt is now close to zero, after peaking at $18 trillion a couple of years ago, according to Bloomberg data.

At the same time, the macro and regulatory environment offers limited incentive for banks — a traditional source of corporate financing, particularly in Europe — to extend their lending book.

In this context, it’s unsurprising to see small-business researcher NFIB’s December business optimism survey¹, which tracks sentiment of small companies in the US, showing a growing proportion of respondents highlighting that credit is harder to get (see chart).

Finding alternative sources of cash

With capital becoming scarce, companies, especially those with complex capital structures and limited access to lending markets, will likely need to find alternative creditors. One option is private credit. Indeed, when done properly, this route can be attractive for both the lender and the borrower. 

On the lending side, private deals tend to offer better risk-adjusted returns, as borrowing terms can be tailored to maximise potential returns while minimising risks. For instance, lenders would include specific terms (such as tighter debt covenants and rate floors) that provide more downside protection for investors. 

On the other hand, for the borrower, private credit deals offer more visibility and customisation, with terms likely to better match the specific needs and characteristics of the borrowing company. The speed of execution may also favour private rather than public debt agreements, especially in volatile periods like the one seen last year. 

When bad times are good

Of course, providing debt when economic momentum is slowing, whether via a public or private channel, isn’t without risk. Yet, private credit can shine during slowdowns. 

A quick look at past performance of private credit funds shows that some of the best returns were achieved by vintages that saw investments take place in a time of economic and financial stress. In fact, data from financial researcher Preqin shows that 2008 was an outstanding year for the median private credit fund manager. 

This may be counter-intuitive, but easily explained by the creditor’s ability to be selective and specific when structuring a financing deal. This often entails stronger guarantees and higher returns for investors, as a willing lender can more or less dictate their terms when access to capital dries up elsewhere.

Higher interest rates a tailwind

Investors may question the appropriateness of investing in credit instruments at a time when US and European interest rates are expected to rise this year. Here again, private credit can be useful. To protect against the risk of interest rates inflating, creditors tend to favour floating rates, embedding a de facto hedge against further rate increases. 

Similarly, higher rates (and scarcer capital) make private credit a more valid option for borrowers. Not so long ago, a high yield issuer may have been able to finance itself in the open market at a cost of around 5%. Today, high yield debt is yielding anywhere between 8% to 10%. At this level, the 15% internal rate of return private debt funds typically seek does not seem prohibitive anymore.

Improved diversification

The attractions of private credit aren’t limited to higher expected returns. Indeed, by incorporating such debt among their investments, investors can further diversify portfolios thanks to the relatively low correlation of the asset class to equities and bonds. This is, in part, due to the illiquidity premium embedded in private credit investments, which investors accept to take a longer-term approach to investing. 

Further, diversification can be achieved at the fund level. To do so, managers often look to lend money across various parts of the capital structure, sectors and geographies. In other words, private credit can help boost returns while reducing risk. 

A growing market segment

Preqin estimates that private debt funds raised $226 billion in 2022, a similar amount to that achieved in 2021. However, ten years ago that number was just $66 billion, showing the increased popularity of the asset class. In fact, credit now represents 17% of total private capital, far behind private equity (57%), but a larger percentage than seen at any time in the last two decades. 

The growth in private credit reflects its perceived attractiveness in an environment where yield is (still) hard to come by. Investors may challenge the premise that with increasing capital chasing limited opportunities, returns may suffer. However, the level of “dry powder”, or investible funds, has been relatively stable at around 2.5 years thanks to private equity funds increasingly tapping the private debt market to finance their deals.

Risks and reward

Private debt investing isn’t without risks. Typically, deals are struck with companies that have limited access to financing and with stretched balance sheets. As a result, the probability of default tends to be higher. Fortunately, thanks to the specific terms inherent to private deals and their more direct structure, recovery rates tend to be higher when defaults occur. 

There is also the illiquidity of private debt instruments to consider. This is why we believe that relying on an experienced manager is essential when investing in private credit. With the right partner, extensive due diligence and the appropriate amount of diversification, we believe that the asset can generate attractive returns with the potential to compensate those who are willing to tolerate the risks.