Why hold private credit? - assessing some of the justifications

Investor flows into ‘private credit' have boomed over the last decade with it now becoming a key part of most diversified portfolios. Yet private credit is a broad classification which encompasses a range of lending strategies provided by non-bank lenders via bilateral loans or small club deals. This broad classification includes various sub-asset classes, each with its own set of risk and return characteristics. Despite this diversity in exposures when justifying the increased allocations to private credit some common justifications are advanced. Some of these justifications are ‘valid’ while others are ‘questionable’ at best. For this reason it is useful to take a closer look at some of the more common justifications used for holding private credit to see how they stack up.

Justification 1 : Lower volatility means lower risk - Questionable

One of the more common reasons cited for investing in private credit, and private assets more generally, is lower price volatility. Though there may be some optical advantages, from a purely investment perspective any benefits arising from lower price volatility are largely illusionary. The true volatility of any financial instrument can only be assessed in an active secondary market where participants continuously assess and reprice risk based upon available information. With private credit the low dispersion in valuations is simply the by product of lack of price discovery as revaluation usually only occurs once a risk event has actually occurred. The lower volatility is accordingly illusory as it is not a reflection of lower risk but simply a by product of the lack of revaluation to reflect that risk. Without such market activity, private credit may appear more stable than it truly is—a phenomenon that’s earned the moniker “volatility laundering.” Indeed by shielding investors from the true volatility associated with such investments ‘volatility laundering’ increases the risk that

1. private credit funds may be tempted to use return smoothing and optimistic valuations to shield investors from realizing the full extent of their losses until it’s too late and
2. investors may over allocate to such asset classes in the false belief that the lack of volatility means that there is lower risk.

Justification 2 : Private credit offers protection against interest rate volatility - Questionable

Most private credit transactions carry floating-rate coupons that reset periodically in line with prevailing interest rates. The claimed benefit of this is that investors wanting to earn a credit premium can do so without needing to take on interest rate risk; i.e. can achieve a purer exposure to the desired premium. While this is true the perceived benefit of private credit in shielding investors from interest rate volatility can be exaggerated. While floating rates may prove beneficial to investors during periods of sharp rate increases interest rates are cyclical hence when they decline, floating-rate instruments do not benefit in the same way as fixed-rate bonds. Therefore, the floating-rate nature of private credit securities does not provide consistent protection across all interest rate environments. Put another way the act of not taking an interest rate exposure is in itself exposing the investor to an interest rate exposure; i.e. avoiding the risk of higher interest rates exposes the investor to lower rates.

The act of not taking an interest rate exposure is even more relevant when one considers that interest rates and credit risk tend to be negatively correlated over the business cycle. As the business cycle deteriorates credit risk increases and, in general, interest rates decline. Accordingly, interest rates tend to provide a natural buffer or risk offset to credit risk. This offset exists whether or not the credit investments are ‘marked to market’ or not. Ironically, an investor, by not taking an interest rate exposure, may unintentionally be increasing the overall risk of their credit exposure rather than reducing it.

Justification 3 : Greater scope to proactively manage outcomes - Questionable

Given the level of information asymmetries within private credit markets, it is sometimes claimed that the strongest argument supporting private credit allocations is the ability for the manager to proactively manage the outcome over the life of the loan. This, it is claimed, justifies investing in private credit as it results in ‘superior’ outcomes. Nowhere is this difference between private and public credit more obvious than in the case of Liability Management Exercises (‘LME’).

LMEs constitute any out-of-court processes, implemented within the terms and confines of a borrower's existing financing documents, pursuant to which the borrower seeks to incur new debt or reorganise its existing indebtedness without triggering a formal default. Typically, this will involve the borrower working with select creditors to incur new debt, extend maturities, enhance financial flexibility via resetting terms/covenants or even refinance. As such LMEs are primarily a form of financial engineering. They rearrange claims on cash flows without necessarily changing the cash flows themselves with the aim of ‘buying time’. The additional time can then be utilised to underwrite a broader restructuring plan or may simply be used to ‘push back’ a maturity wall thereby providing either (a) a more opportune time to exit the loan and/or (b) strengthen the credits position in the event of eventual default.

Importantly LMEs are most effective when a borrower is dealing with a small number of sophisticated lenders with an in-depth understanding of the business. For this reason the ability of public debt markets to facilitate such transactions is more limited with debt holders more likely to simply ‘vote with their feet’ and sell the debt to a restructuring expert, often a private credit fund, in the event of major credit issues. Private credit accordingly provides investors with the opportunity to more closely work with borrowers during good times and bad to optimise the return generate from the exposure.

This raises the question as to whether this ability to more proactively manage outcomes is a justification for holding private credit or simply a prerequisite for holding private credit? As private credit lends to borrowers who

1. typically can’t get access to bank credit or public markets and
2. comprise illiquid loans that have to be held to maturity/repayment

the more proactive management style is simply offsetting other risks. Ultimately proactive management is less a justification and more a requirement for holding private credit. Investors need to choose those lenders that have the capability to leverage off information asymmetries to maximise the level of additional premium retained by investors over the credit cycle.

Justification 4: Private credit is lower risk than high yield - Questionable

It is often argued that private credit incorporates a lower level of credit risk than high yield as it tends to comprise secured loans which are higher in the capital structure. Reinforcing this view is that private credit funds often highlight the quality of the collateral embedded in their loans and the strict covenants as reasons for potentially lower losses in the event of a borrower defaulting. Collateral or security refers to the assets pledged by the borrower to the investor, which can be used to recover debt in the event of default. Covenants are restrictions placed on the borrower, such as limits on leverage or changes in ownership, designed to protect investors and reduce downside risk. This contrasts with high yield which tends to be ‘lighter’ in terms of collateral and covenants.

Yet this is not the entire story as while collateral and covenants provide greater protection in the event of default they do not reduce the risk of default. Often private credit will be extended to smaller, lower rated companies lacking in solid collateral. Further private credit transactions may tend to be more bespoke and complex being extended to companies which may be unable or unwilling to seek credit through the more traditional means. The result is a higher risk profile in private credit as borrowers are typically more highly levered, have a higher risk of default and do not have the fallback position of accessing the more traditional forms of debt capital via bank debt or public bond markets.

Further complicating the situation is the difference in the approach to managing risk. In high yield markets the higher liquidity allows investors to more proactively respond to changing dynamics and risk profiles by trading loans. If a loan has issues then it is often easier for high yield investors to simply sell the exposure and move on. By contrast, as already noted, private credit managers need to adopt a more ‘lend and hold to maturity’ approach to portfolio management. For this reason private credit and equity are often viewed as being more closely intertwined and overlapping. Indeed private credit, though further up the capital structure, has a lot in common with equity. For example private creditors often (i) do participate in capital growth, (ii) are interested in the firm’s profit maximisation, (iii) there is less conflict between the interests of equity and debt providers, and (iv) corporate loan financing agreements are expected to be renegotiated. The greater overlap within private markets makes the distinction between private credit and equity more blurred further complicating not only the assessment of risk but also pricing.

Justification 6 : Can earn a yield premium - Valid

The most common justification for holding private credit, namely the ability to earn a yield premium over more liquid alternatives of comparable credit risk, is incontrovertible. Data for US and European markets has shown that over the long term private credit does generate a material yield premium of around 200-300 bps p.a. over comparable fixed income alternatives such as high yield. More problematic is identifying what this premium actually represents.

On the one hand many investors argue that the higher return represents an illiquidity premium. Liquidity refers to how easily an asset can be traded and thereby converted to cash. The illiquidity premium is the additional return investors expect as compensation for the inconvenience of investing into assets that are not readily tradable/convertible into cash. Theoretically an illiquidity premium is a known and accepted tradeoff which should generate an additional return for accepting reduced liquidity.

The issue with the illiquidity premium is that it assumes ‘all else is equal’ with the only difference being liquidity. The complication occurs in private credit when investors try and separate the impacts of an illiquidity premium from those of what may be termed the ‘complexity premium’. The complexity premium is the higher return resulting from the ability to access and tackle complex situations, and the skill needed to execute these types of deals. Extraction of a complexity premium requires :

1. a situation that is particularly complex in terms of access, risks and opportunities and

1. deployment of rare skills to source, select and negotiate, develop and exit the investment.

Negotiating these complex situations can often take time with the value creation process often requiring a degree of illiquidity. What is often termed as a illiquidity premium may in reality be a complexity premium.

Though the total yield premium is likely to be a combination of both illiquidity and complexity premiums, distinguishing between the two premiums is not just an academic exercise as one is a beta exposure while the other is an alpha exposure. Conceptually the illiquidity premium is available to all investors who are prepared to sacrifice liquidity. It can accordingly be invested in naively with the knowledge that over the credit cycle it will be earned; i.e. it is a beta or market exposure. By contrast capturing the complexity premium requires not only a complex situation but also identifying the appropriate skills to engage with it successfully; i.e. it is an alpha or value add exposure. Being alpha exposures complexity premiums are more difficult to earn via naive investing. A higher level of understanding and selectivity is therefore required to extract them over the credit cycle. Identifying which premium private credit investors are being compensated for is critical to ensuring the correct approach to accessing the higher returns. So while on the one hand it is incontrovertible that investors in private credit markets can earn a premium for the same level of credit risk compared to more liquid alternatives what that premium comprises is variable. In turn the composition of the premium impacts upon how it should be accessed.

Justification 5 : Private credit offers diversification benefits - Valid

It is incontrovertible that private credit provides the ability to access more specialist strategies which assist in diversifying current high yield and traditional fixed income credit exposures. As the borrowers in private credit markets are those that cannot access either bank facilities or public markets there is a natural diversification at the borrower level. This means that naively investing in private credit can increase counterparty diversification. A more selective approach to strategy selection may also bring additional diversification across sectors, geography, collateral type etc.

Taking a closer look at the justifications for holding private credit highlights that the valid arguments are the ability to earn a premium and increase diversification. Yet extracting the most from higher premiums and diversification depends upon how the private credit strategies are implemented : naive implementation of private credit strategies risks lessening the ability of the investor to capture the benefits from the exposure over a full credit cycle. Investors accordingly need to approach such strategies with care and identify clear areas of informational asymmetry and/or skill to maximise the benefits from adding private credit exposures to their portfolios.