Defining Private Credit and Its Use Cases

Credit is one of the most widely used terms in the English language. Individuals use it often when referring to their credit score.

The root word for Credit is Credible.

As in believable.

In the context of finance, credit denotes the belief that one will be paid back if one lends out money.

The Global Financial Crisis (GFC) was a credit crisis that exposed a rot in the core of the system. Financial institutions lost faith that they were able to be paid back by borrowers. It was a crisis of creditability that started with easy money lent to precarious borrowers and manifested into those loans packaged to the public without accounting for the appropriate risk.

Since the GFC, banks have tightened credit standards and shied away from typical lending done in prior years, creating a lending gap. The lending gap has created an opportunity for private credit to fill the void left by banks and, importantly, allow private investors the ability to participate in the market of higher-yielding loans.

The main difference between Private Credit and Public Credit is their liquidity. Public credit is debt issued or traded on the public markets. Private credit is privately originated or negotiated investments, comprising potentially higher-yielding, illiquid opportunities across a range of risk/return profiles.

Blackrock writes - “Private credit represents part of the broader alternatives universe, referring to non-traditional assets relying to some degree on an illiquidity risk premium to help drive excess returns. Private credit covers a broad spectrum, from opportunistic and distressed debt to middle-market investing, and specialty finance.”

The liquidity risk premium refers to the excess return that investors receive for investing in higher-risk securities that are not readily traded in the public markets.

Because Private Credit is not as easy to purchase, investors in this space can invest in situations that are harder to understand. Private Creditors can lend to companies experiencing financial hardship, referred to by Blackrock as opportunistic and distressed debt.

A popular form of Private Credit investing is loans to middle-market companies. Middle-market companies are large enough to borrow large sums of money from investors, but not large enough to be recognized by the average investor. Given these companies are not household names like Amazon or Apple, they are not able to issue debt in the public market. Additionally, since banks have been more selective in their lending, as mentioned above, these companies are not able to obtain the financing needed. An area that was serviced by financial institutions is now a growing sector for private credit to service.

• Yield: A combination of the liquidity premium and bespoke nature of private fixed-income investments relative to public bonds allow private fixed-income investors to capture a spread premium in excess of comparable public issuers or indices, as well as the potential for additional income associated with fees charged to the issuer.
• Diversification: The private fixed income market offers investors the opportunity to invest in unique transactions and issuers not available to public bond investors.
• Risk management: Private fixed income investors may benefit from deal structures that could be more robust than public market transactions, including collateral and financial covenants that allow investors to get back to the negotiating table in the event of credit deterioration.

  However, no investment strategy is free of material risks or limitations. Some of those risks and limitations for private credit include:

• Lack of Liquidity: The reason a higher yield is paid for less liquid investments is because these investments are harder to exit. Publicly traded markets allow securities to be sold easily, so long as one is willing to lower their asking price. Finding buyers of Private Credit is trickier.
• Smaller Companies: Middle-market companies are smaller than average companies found in the S&P 500. These companies have fewer resources to weather a rough patch and pay off their loans in adverse scenarios.
• Less Policy Support: The Fed came to the rescue of the public bond markets in 2020 when there was a liquidity crisis by buying ETFs of publicly traded bonds. Policy support for smaller private businesses was much harder to administrate and navigate.

A current gauge of high yield spreads came in at 3.26%. Adding the 10-year yield pictured above to this gives an all-in yield of 4.56%.

ICE BofA US High Yield Index Option-Adjusted Spread

Compare this paltry yield to the last three CPI readings, which appear to be accelerating higher, shown below, and this exposure to high yield credit has not preserved investors’ purchasing power.

U.S. Consumer Price Index (CPI) YoY

Adding insult to injury, these CPI prints have not included increasing home prices or rents. These numbers are set to affect the upcoming numbers. MarketWatch writes that they “will continue to weigh on official measures like the consumer price index given the time lags that occur.”

According to an Institutional Investor interview with David Ross, head of Northleaf Capital Partners’ Private Credit program, the asset class “has provided stability — in terms of low loss rates and limited volatility — and can deliver relatively high cash yields even on a loss-adjusted basis.”

The chart below shows it has lower loss rates than those high-yield bonds we referenced earlier.

5-year Cumulative Loss Rate by Bond/ Loan Category

Another advantage includes the ability to get floating rates.

However, the lower loss rates are extremely important. We did not even include loss rates before when discussing how all-in yields on high-yield instruments are lagging current inflation levels. When you include loss rates on high-yield public credit, that eats into returns even more.

Notice that the higher grades of public debt still have better default rates. This shows that Private Credit investors are more discerning than their counterparts who invest in high-yield public credit, but they still take more risk than investment grade investors.

There are multiple reasons why such an interesting opportunity in Private Credit exists. One source of return is the liquidity premium that is available since the bonds do not trade in liquid markets.

Another reason for this opportunity according to Mr. Ross is, “banks were historically the primary source of loans for private companies while institutional investors were focused on predominantly liquid loans and niche mezzanine junior debt. That all changed after the global financial crisis when stricter regulation led banks to reduce the size of their balance sheets.”

The restrictions on the big banks are the Alternatives Investor’s opportunity. Notice in the 5-year loss rate chart that the companies targeted by private credit are middle-market companies.

The largest companies in the world can access public debt markets. Not only can they access these markets, at this point they have the ability to borrow below the current inflation rate.

Smaller companies do not have this luxury, but they may still need capital to run and grow their operations. This obviously comes with risk, as the companies do not have the large balance sheets that allow many larger companies to refinance maturing debt easily.

Lastly, the Federal Reserve made waves last year when they partnered with the Treasury Department on a special purpose vehicle to purchase publicly traded credit. This was controversial at the time because the Fed is not supposed to be buying corporate debt.

Jeff Gundlach, the CEO of major bond investor DoubleLine Capital, explained at the time, “The Federal Reserve is presently acting in blatant non-compliance with the Federal Reserve Act of 1913. An institution violating the rules of its own charter is de facto admitting that said institution has failed and is fundamentally broken.”

So, while the Fed could conceivably attempt to bail out private credit in the future, they did not do so this past crisis like they did for publicly traded debt securities. This is an added risk of investing in Private Credit.

Private Credit investing is similar to public credit investing. The main difference between the two is the ease with which public credit investors can buy and sell debt securities. Private Creditors do not have this luxury and thus take on more risk. For this reason, Private Credit Investors demand a liquidity premium.

Investors in alternatives have a larger opportunity set in Private Credit because banks have been constrained by regulations since the Global Financial Crisis after they measured their credit risk poorly.

Private Credit investors often invest in more opportunistic, distressed, and middle-market situations than do public credit investors.

This is evidenced by the higher default rates seen by Private Credit investors relative to investment- grade public credit. Still, many Private Middle-Market investors have seen lower default rates than their counterparts in the public high-yield space.

As discussed in prior notes, the 60/40 portfolio is challenged by the low yields on offer in the risk-free market.

Yet publicly traded, high-yield bonds don’t even add enough returns to cover the cost of inflationary pressures and this is BEFORE accounting for loss rates. Beyond the extremely low risk-free rates, credit spreads are supposed to compensate investors for this risk of defaults. Currently, Private Credit is seeing lower default rates relative to publicly traded high yield securities.

While this may seem justified because the Fed purchased some high yield securities earlier this year, they are now in the process of unwinding these purchases.

Meanwhile, as we discussed in our Fed policy primer, the question of whether the Fed will utilize its tools to stop inflationary pressures is in doubt.

By taking a more active approach and harnessing alternatives, investors can still earn satisfactory returns in excess of inflation and publicly traded debt.

Investors in risk-free treasuries and publicly traded high-yield bonds need to BELIEVE that the Fed will do what it takes to stop inflation.