Private Credit: Why Investors Should Take a Hard Look at this Asset Class

Over the past several years, private credit has grown in popularity among investors looking for higher yields and less volatility. As a result, private credit is projected to grow from approximately $848 billion in 2020 to $1.46 trillion by the end of 2025—an astounding 72 percent increase1.

As attractive as it is, private credit remains mysterious to many investors. Below, Chris Boehm, Executive Managing Director, Cresset Private Capital, helps shed light on this compelling asset class—what it is, what makes it so appealing, what has driven the surge of interest in this asset class, and where he sees it headed.

Chris, what exactly is private credit? Can you provide some examples?

Chris: The term “private credit” represents a type of company loan that does not trade on a public exchange (like bonds do, for example). These loans are typically provided by investors via alternative asset management firms, held in investment funds, and supply private companies with capital and financing solutions that they are unable to access through public markets.

Private credit loans can take the form of senior-secured loans, asset-based loans (ABLs), second lien, and mezzanine debt. The main difference between these loans is that they are prioritized differently within the capital stack, meaning in the event of a liquidation, return of capital goes to senior-secured loans first, then second lien loans, and so on. Once all debt has been paid, the remaining capital is distributed to equity holders. The higher the priority in the capital stack, the lower the investment risk and the lower the yield, and vice versa.

How has private credit grown in the last 5 – 10 years?

Chris: There are several factors driving the record private credit activity over the past decade:

  • Investors have increased their capital allocations to private investments, and by extension, private credit.
  • After the global financial crisis, stricter regulations led banks to reduce the size of their balance sheets. Historically, though, traditional banks were the primary loan source for private companies, while institutional investors were more focused on liquid loans and niche debt. The shift from traditional bank lending to non-bank lending created more flexible and customizable credit solutions, allowing lenders to tailor mutually attractive terms (i.e., no more one-size-fits-all from large banks).
  • The size of the private market economy has grown substantially as more companies are staying private for longer periods of time; therefore, more companies need private financing solutions to fund growth.
  • Private credit offers an alternative to low-yielding traditional investments, like bonds, and helps satisfy investors’ appetite for cash flow.

Can you elaborate on what makes private credit attractive to investors now?

Chris: First, higher yields. Private credit offers an attractive yield relative to high-yield bonds with a historically lower default rate, translating to better risk-adjusted returns.

Additionally, lenders have more flexibility with structure and can tailor a loan to the specific risk / return profile of a company, creating more favorable investor terms through securitization, covenants, and appropriate pricing.

At the same time, because these loans are private and illiquid, investors demand a premium for that illiquidity. That helps drive yields higher when compared to their public credit counterparts.

How could high inflation and rising interest rates impact the private credit market going forward?

Chris: Many private credit portfolios consist of floating interest rate loans that provide a natural hedge to rising rates, which should help keep inflation-adjusted returns attractive.

What do investors who are new to private credit need to know about this asset class?

Chris: There are many nuances in selecting an appropriate private credit fund or manager to fit an investor’s needs. For example, higher yield typically means higher risk, which can come in the form of lending to riskier industries, being more junior in the capital stack, higher total leverage on a given company, or high leverage on the portfolio as many managers will use varying amounts of leverage to increase yield.

It’s also important to understand past performance and target portfolio characteristics. Does the firm have a high default rate on its portfolio loans? Is it typically able to recapture its capital in the event of a default when losses occur? How diversified is the fund’s portfolio? What portion of its loans are floating interest rate versus fixed interest rate? What type of company is the lender lending to and how much leverage is it providing?

What types of investors should be exploring private credit?

Chris:  At Cresset Partners, we have primarily used private credit to supplement investors’ current cash-flow needs. Private credit comes with varying forms of liquidity, so investors need to understand redemption mechanisms and that they may not be able to liquidate their funds immediately. Private credit can also help lower an investor’s correlation to the market and provide access to the vast middle market economy that has performed well over the past decade.

What is the outlook for private credit in 2022 and beyond?

Chris: We believe current trends will continue through this year and into next. Interest rates, inflation, and economic growth would have to significantly vary from what the market is anticipating to create any major disruptions to the asset class. The combination of a large backlog of opportunities and significant “dry powder,” or investment firms’ available cash, will continue to drive supply. On the demand side, investors seem to have an insatiable appetite for yield, and private credit can be an attractive way to provide predictable, risk-adjusted current income. Because of the massive amount of demand and strong tailwinds, we anticipate continued growth for private credit over the next several years.

Contact Cresset Partners to learn more about private credit.

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