Is Private Credit a Good Investment?

Private Credit is one of the hottest asset classes today. Recently, a colossal $4.25 billion acquisition of a Baxter International Inc. division was financed not through conventional channels like banks, but through private credit supplied by entities like Ares Management, Blackstone, Blue Owl Capital, and HPS Investment Partners. Investors piling into private credit are being seduced by higher returns and seemingly lower risk.

But, what exactly is private credit, and why is it so popular with both investors and borrowers alike? Is private credit a good investment? Or, should you avoid the private credit hype?

Understanding Private Credit

Private credit is essentially a form of lending where specialized asset managers provide loans to businesses. Unlike traditional banks, these lenders often customize loans for each borrower and do not trade the debt. Flush with capital, private credit funds are doling out loans at advantageous rates. Private credit as an asset class has come into prominence in recent years, especially after the Dodd-Frank Act of 2010 nudged riskier lending outside the banking sector.

Private credit closely resembles private equity – both pool capital from investors, such as pension funds and insurance companies. However, while private equity firms often acquire partial or complete ownership of companies, private credit firms simply lend money, putting themselves first in line for repayment if the borrower defaults.

The Meteoric Rise

The private credit market has witnessed explosive growth in recent years. According to Preqin Ltd, the global private debt grew from just over $300 billion at the end of 2010 to a staggering $1.5 trillion as of September 2022. Moreover, projections indicate that this number could reach $2.2 trillion by 2027.

One factor behind this burgeoning growth is the search for higher yields. With interest rates at historical lows until recently, investors were on the lookout for more lucrative opportunities. Private credit emerged over the past two decades as the golden goose, offering attractive returns compared to other investments. For instance, the Cliffwater Direct Lending Index, which represents around $280 billion of private loans to small and midsize companies, was up by 6.29% in 2022, a year when the S&P 500 experienced a loss of about 19%.

Murky Waters

However, private credit is not without its challenges and concerns. Firstly, the loans typically have floating interest rates. This means that while investors enjoy higher returns as rates rise, it can also place a burden on borrowers whose repayments can double, increasing the risk of default.

Secondly, and more importantly, there is an issue with transparency. Since private credit loans are usually held until maturity, lenders have considerable discretion in determining the current market value of loans in their portfolios. This could lead to overly optimistic valuations, potentially disguising troubled investments inside of private credit funds.

Furthermore, the regulatory landscape for private credit is sparse compared to the traditional banking sector. While the Federal Reserve does not currently view private credit as systemically risky, the lack of transparency makes it difficult to accurately assess risks to the broader financial system.

Is the Tide Turning on Private Credit?

As the private credit hype show reaches its crescendo, investors should be cautious. With defaults rising, the opacity in valuations, and a lack of regulatory oversight, the private credit market is entering uncharted waters.

Moreover, it’s essential for regulators and policymakers to keep a close watch on this burgeoning sector. As private credit funds are not subject to the same scrutiny as traditional banks, the call for increased disclosure and oversight is gaining momentum.

Frighteningly, we’ve now reached the point in the life-cycle of private credit funds when they are being sold to average investors by way of retail brokerage channels. Many investment advisors are now touting private credit (and private equity in general) as a way to “beat the markets”. But, how good can the returns possibly be when everyone has access to such “exclusive” private market investments?

Growth of Private Credit

Private credit became supercharged following the 2008 financial crisis and passing of the Dodd-Frank Act which limited the ability of banks to make certain types of loans. Regulators were trying to ensure banks and other regulated financial institutions didn’t get mixed up in risky corporate lending. Since, such risky loans could pose risks to the broader financial system.

The result of these regulatory changes was a shift away from regulated banks towards private credit. Private credit funds filled the gap left by traditional commercial bank lending. Seizing the opportunity, private credit funds raised money directly from investors to make loans directly to companies; by-passing the regulated financial system and earning high fees in the process.

A Boom for Private Credit

Over the course of the past two decades, private credit has boomed. Investors have become increasingly enthusiastic about funding private credit funds because the returns seem so good while the risks also seem lower.

However, these returns have been earned during a low interest rate environment when credit risks have been benign. Many private credit funds have not been tested during a recession.

Do Investors Understand the Risks?

With interest rates now rising again, the pressure on many private credit funds is mounting. Unfortunately, most investors are unaware of this new reality. Partly because many private credit funds hold their loans to maturity. They typically don’t mark those loans to market based on their current value. Such a valuation practice paints a rosy picture of the true nature of such lending. And, keeps many private credit investors in the dark; until its too late.

Private Credit Investors: Pension Funds

Who have been the most enthusiastic private credit investors? Pension funds. Partly because many pension funds are trying to earn their way out of funding deficits, they are taking on more risk then is prudent.

Pensions also love private credit because it seems like a good way to beat traditional bond markets. Egg-head employees working for pension funds seem to forget that a free lunch never exists.

Private Credit Investors: Family Offices

Why might family offices be so enthusiastic about private credit? Partly, they’re caught up in the hype. But, also due to the potential for higher fees. If investing were as simple as holding a diversified portfolio of stocks, bonds, and real estate, then why would anyone need to pay high fees for fancy investment advice?

What are the Risks?

For investors, the risks of private credit are twofold. Firstly, with rates rising, the value of many loans should be falling. Expect, many private credit funds do not mark-to-market. This means may private credit funds are worth a lot less than their investors believe. Secondly, private credit investments are illiquid. They cannot be easy sold. But to the private credit salesperson, such illiquidity is a benefit. Since, they claim higher returns can be achieved from the “illiquidity premium”. The reality is many private credit funds may be stuck with bad debt if credit conditions deteriorate during an economic downturn.

End of Easy Money

With easy money coming to an end, and interest rates rising, we’ll soon see which investors are swimming naked. Higher interest rates and an economic downturn could spell disaster for many private credit funds. Borrowing costs will increase, and as a result, interest payments on floating-rate loans will also rise. While this could lead to higher returns for investors initially, it might also increase the risk of borrower defaults.

Private Credit: Regulatory Scrutiny

As market conditions change, regulatory bodies are paying more attention to non-traditional lending such as private credit. Higher regulatory scrutiny and new lending regulations will impact the operations and returns of private credit providers.

Purveyors of private credit funds may find they are being squeezed on both ends. On one side, the market is offering lower returns. This will eventually decrease demand from investors. On the other side, law makers will be taking a closer look at how private credits funds are regulated. This will increase the regulatory costs for private credit funds.

Conclusion

Do you need private credit in your investment portfolio? Probably not. Most financial goals can be achieved using a traditional mix of stocks, bonds, and real estate. If you’re an investor with an impact mandate, you should probably focus on more targeted investments towards innovative funds & businesses that promote your specific values. Private credit as an asset class will not necessarily satisfy your impact investing goals.

Private credit, which has been on a meteoric rise over the past decade, finds itself at a crossroads. With its bespoke lending model, it emerged as a lucrative alternative to traditional banking channels, attracting massive attention from investors, particularly pension funds and family offices. However, as we transition out of the era of easy money, the landscape for private credit is set to evolve.

The rising interest rates pose a double-edged sword; while potentially bringing higher returns initially, they also herald increasing risks due to borrower defaults. Add to this the lack of transparency in valuations, coupled with the fact that many private credit funds have not yet weathered a recession, and it’s clear that caution should be the order of the day for investors.

Moreover, as private credit seeps into the portfolios of average investors, the stakes get higher. The sector which has so far enjoyed relative freedom from regulatory shackles is likely to face increased scrutiny. This is not only prudent but essential to ensure a level playing field for financial market competition.

For investors, both institutional and retail, it’s imperative to understand the changing dynamics and inherent risks of private credit. Diversification, thorough due diligence, and an informed approach are key. Private credit can still be a valuable component of a well-rounded portfolio, but it should be approached with a realistic understanding of the risks and rewards. Investors should still consider traditional bond markets where liquidity and transparency are highest.

Private credit has proven its mettle as a formidable force in the finance sector, but it now faces the trials of shifting financial tides. Through prudent management, informed investing, and regulatory vigilance, it can continue to play a significant role in the investment landscape. However, the unbridled enthusiasm for private credit should now give way to a more measured, cautious, and sustainable approach going forward.