Hear from the experienced players in the field
The US private credit market may have been around for over two decades now, but it’s only in the years since the global financial crisis (GFC) that it has really picked up steam. In 2010, global private debt AUM stood at $325bn, according to Preqin, yet by 2020, this had grown to $848bn.
“Private debt has risen to become its own asset class since the GFC,” says David Scopelliti, Global Head of Private Debt at Mercer Alternatives. “The retrenchment of banks as a result of regulation and the need to de-risk their balance sheets has come at a time of significant increases in private equity dry powder. Private credit is now critical as a funding source to companies - there will be ongoing opportunities.”
While there is clearly demand from companies for private debt in the absence of bank funding, what is driving the supply of finance from LPs in today’s market?
As has been the case since the GFC, investors are having to look long and hard for sources of yield in a low interest environment and private credit has been a major beneficiary of this quest. “Central bank policies of keeping interest rates at zero (or lower) pushes investors out on the risk curve, driving investment into riskier and riskier assets,” says Brandon Laughren, CIO of The Laughren Group. “We invest in private credit because, in our view, what’s available in public markets does not appropriately compensate investors for the risks they are taking. In private markets, you can find outperformance, particularly in capacity-constrained strategies.”
This returns disparity between public and private debt is what originally drew Arizona Public Safety Retirement System to private credit in the immediate aftermath of the GFC. “We started investing in private credit in 2008,” explains Shan Chen Portfolio Manager at AZ PSPRS. “We got into it by accident because at the time we could see that investment grade credits were at perhaps 80c on the dollar but that the price recovered quickly to par. That led us to private credit, where there was a great dislocation at the time - we generated IRRs of upwards of 20%. Since then, we have built up our allocation, starting at around 8% to today’s 22% target.”
Yet Chen warns that this level of performance is unlikely in today’s market, given its increased size and the higher levels of liquidity more broadly in the system. “Returns are harder to find now and, where historically, you could average 9% to 10%, it’s now more like 7%,” he says. “That’s still a good return, but it will get even tougher in future.”
However, many believe that private credit’s performance compared with some other asset classes remains attractive. Pennsylvania State Employees’ Retirement System is a relative newcomer to private credit, having started its program in 2017. Its Director of Alternative Investments, Ryan Morse, explains the plan’s thinking around its entry to the asset class. “We had historically been investors in private equity funds and we saw that many of the larger firms had developed private credit strategies,” he says. “We believed that presented interesting opportunities but we didn’t at the time have a bucket to put it into. Before 2017, we had been a large allocator to hedge funds, but they hadn’t been delivering for a while, so we reallocated a significant portion of that capital to private credit. It was a logical place to put our money since it is a large and growing market with sophisticated deployment and an attractive risk/reward profile.”
Returns are far from the only attraction for LP. Many point to the diversification benefits private credit provides across a number of different fronts, including the scale of the addressable market. “A key benefit of private credit is to generate additional alpha,” says Jeff Behring, Director, Private Debt and Equity at Northwestern Mutual Capital, which mainly invests directly, but occasionally backs managers in more niche strategies. “But diversification is an underappreciated yet equally important benefit. There are only so many Amazons and Walmarts that an institutional investor can buy in public debt markets and yet there is a vast quantity of private companies that prefer to avoid the reporting burdens of issuing publicly-traded debt. Private assets across multiple asset classes make up over 40% of our portfolio.”
The sheer number and scope of companies and situations needing finance outside the public markets means many investors can fine-tune their private credit allocations and gain exposure to a broad variety of assets, including to some of the highly specialist areas that have emerged over recent years.
“We have a global credit strategy with exposure to a diversified range of investments, both public and private,” says Jennifer Hartviksen, Managing Director, Global Credit, IMCO. “We seek to generate alpha through a diversified credit portfolio, which on the private side includes areas such as alternative credit, direct middle-market loans, real-asset loans, healthcare and pharma royalties and aircraft leasing. This diversification across segments of the private credit market provides us with differentiated credit revenue streams that are not necessarily correlated to public credit markets. Private credit offers us unique, diversifying exposures that we can’t get from public markets.”
Specialty strategies are also a particular draw for Mark Perry, Managing Director at Wilshire. “Today, you can find niche strategies with very attractive returns on both an absolute and relative basis with differentiated managers in inefficient markets,” he says. “These can be achieved with attractive risk metrics, including through diversification, because the risk in these underlying strategies is fundamentally different from other parts of the portfolio. It’s a really exciting area for us.”
Overall, it’s the breadth of opportunity within private credit that excites many LPs. Funds and investors can increasingly take advantage of their ability to pivot from performing credits in different parts of the credit spectrum through to special and distressed situations and to niche and specialty sectors.
This plethora of options means LPs need to take time to understand precisely what they are committing to. “Nuances really matter,” says Scopelliti. “A lot of names can be bandied around – senior, stretch senior, unitranche and so on – so you have to really dig in to understand the attachment points.” But it also means that knowledgeable and/or well advised investors can create portfolios that closely match their risk and return appetites. Private credit’s growth since the GFC has been impressive; expansion in the next few years could be equally so.
