Private credit as an asset class has grown in status since the global financial crisis, but is it a solid inflation hedge, what returns can be seen, and what does the future hold? Room151 got the thoughts of Hymans Robertson’s Penny Cochrane, LGPS Central’s Gordon Ross, and LPPI’s Andrew John.
*This feature was first published in the Q1 2024 edition of the Private Markets Profile, which you can read here.
Private credit has gained considerable appeal in recent times and continues to offer an attractive return premium relative to public markets.
According to LGPS Central CIO Gordon Ross, there are several reasons for the rise of private credit. First, he says, it serves as an excellent portfolio diversifier, offering investors an alternative in a market marked by ongoing mergers in the banking sector and concerns about liquidity.
The asset class rose to prominence in the aftermath of the global financial crisis, Ross notes, filling the void left by the retreat of traditional lenders. Tightening lending criteria due to regulatory requirements further propelled private credit’s issuance and terms have been investor friendly, he notes.
“Over the past decade, the private credit industry has adapted, including easing covenants. In recent years, these covenants have been tightening, providing enhanced financial and legal protection to the investor,” Ross comments.
“The floating rate environment of the private debt market has seen yields increase as base rates rise. Whilst this might lead to borrowers having to adjust to higher debt servicing costs, the threat of significantly increased defaults seems limited at this time.”
Penny Cochrane, senior investment research consultant, investment DB at Hymans Robertson, says the attractiveness of private credit depends on how it’s being assessed.
“From a historical point of view, private credit returns are the highest since the global financial crisis. Most private credit assets have a floating rate, which means loans have seen their interest payments reset and rise in line with interest rates. This is improving the return profile of existing loans and providing a great underpinning for newly originated loans,” she says.
“If we compare private credit to public fixed income, the relative value dynamic has shifted as there has been an historic repricing of conventional bonds. However, over the longer term, private credit has proved to be attractive for investors who can withstand the illiquidity.”
Andrew John, investment director – credit at Local Pensions Partnership Investments (LPPI), says recent new origination within private credit has been particularly attractive. “Anecdotally, we are seeing our external managers lending at spreads in excess of 100bps wider than two years ago. At the same time leverage levels have come in by approximately one turn,” he reports.
“Other terms have also been more lender friendly with the ability to place stricter covenants and tighter leakage protections. You are also underwriting companies that have just lived through the current inflationary period so you can have some confidence that they are adapting where necessary.”
Inflation hedge
Is private credit now one of the best hedges against inflation? Opinions vary. Ross says private credit “stands out” as one of the better hedges against inflation, especially when investments are linked to sectors impacted by inflation. “These are primarily real asset debt opportunities, typically infrastructure and real estate backed. Its value lies in its ability to provide a hedge against the eroding effects of inflation that is not usually attainable in publicly quoted traditional assets,” he explains.
John thinks that private credit has one key structural property that provides the asset class with an “implicit but imperfect” hedge against inflation. A large proportion of the loans in the market benefit from having floating rate coupons, he says, and this means that the yield on the loans increases with interest rates.
“Taking the expectation that central banks will use base rate hikes as a monetary policy tool during periods of inflation we can infer that the yield of portfolio of private credit will be somewhat correlated to inflation, albeit with a lag, providing inflation participation.”
The lower duration nature of floating rate assets also means that private credit is typically less impacted by the interest rate driven repricing headwind faced by other areas of the credit market. “This is certainly something we have observed over the last couple of years with the private credit market producing strong risk-adjusted returns,” John says.
The prevailing growth environment must also be considered as a key factor alongside inflation, he adds. “Taking corporate direct lending as an example, there may be periods where growth remains strong despite elevated levels of inflation which helps underlying portfolio company revenue/profits accelerate alongside higher input costs to the point where there may not be a detrimental impact on returns,” he comments.
This contrasts with periods of slow growth and higher inflation (stagflation) where an increase in input costs may not be able to be passed onto customers in a timely manner, and companies will have a higher cost burden that they will need to pay to their lenders.
“These factors could lead to an increase in default rates across the market, making external manager selection vital in our view,” adds John. “With this in mind, we generally focus on allocating capital to external managers and strategies that prioritise conservative credit underwriting and focus on seniority in the capital structure.”
As a counterpoint to these opinions, Cochrane states that private credit “isn’t a particularly great hedge against inflation”. She explains: “While floating rate instruments offer an implicit hedge against inflation, assuming that base rates rise to combat higher inflation, there are better-suited hedges to inflation for investors.”
Results and opportunities
John says LPPI’s private credit allocation has played a key role in achieving the company’s target for its credit programme – which invests across a combination of public and private credit – of beating a public market benchmark by 1-3% per annum over a full market cycle. “This is something we have achieved over one, three and five year periods through to June 2023,” he says.
Ultimately, private credit is an attractive asset class for institutional investors who have a long investment horizon that enables them to access the illiquidity and complexity premium on offer in the space, he thinks. “Given the potential resilience to inflation we would add that the space is attractive for investors with inflation linked liabilities like LGPS funds,” he adds.
Manager and strategy selection is key to success, along with diversification. At LPPI this is achieved by allocating across three core strategies within private credit – corporate direct lending, real estate debt, and asset-based lending.
Ross says private credit funds typically focus on specific strategies, and their “performance has generally aligned with expectations, delivering steady returns”. Currently, LGPS Central offers four funds to LGPS partner funds “with the higher return mandate targeting 12-14% net with the lower return fund aiming for 6-8% net internal rate of return (IRR)”.
Like John, he believes private credit is a natural fit for a diversified portfolio, offering a complement to other private market investments. Diversification is particularly important for institutional investors, local authorities, and pension funds, Ross thinks. “A global cross-section of investments, avoiding concentration in one sector or geography, is recommended. A holistic approach, considering various factors, proves beneficial in optimising returns and managing risks.”
Opportunities in private credit are present, especially with the upcoming launch of two low-risk-plus funds, Ross says. And LGPS Central has “seen interest in inflation-linked deals and direct lending sectors, infrastructure and real estate debt”. These display lending viability driven by long term contractual cash flows and lending safety driven by the tangible nature of the asset. Lending viability leads to lower default environments and lending safety all but eliminates losses, he adds.
Cochrane notes that private credit returns can be variable, and depend on the type of private credit being talked about. “With standard corporate direct lending, before the recent rate rises, the senior part of the capital structure was around 6–8% net IRR. Now European direct lending managers are indicating around 8–10% net return for funds being raised and invested now,” she reports.
LGPS and pension funds are better suited to the long-term nature of these assets, though. “These funds don’t have any capital requirements, so they can be as opportunistic (or conservative) as their own risk tolerance and requirements allow them to be,” she reports. “Being an open-ended scheme means that they can take illiquidity risk so they would be looking at private debt alongside other risk assets. Whereas for corporate DB schemes, specifically those who have significantly de-risked, private debt (or any illiquid holding) could potentially be the riskiest thing in their portfolios.”
In general, she says private credit allocation should be built around direct corporate lending, which is the “most accessible” part of the market. “Depending on a client’s risk tolerance, they can then have smaller allocations to more opportunistic areas if they have a higher risk tolerance or lower risk strategies such as investment grade opportunities or real asset-backed securities if they have lower risk tolerance,” Cochrane says.
Opportunities also exist outside direct lending, she adds. “One area we’re looking at is asset-backed lending, which would include private ABS. This offers a different underlying risk profile by diversifying the direct lending risk. Direct lending is corporate risk whereas asset-backed lending – depending on what the asset is, of course can be consumer risk, real asset risk or uncorrelated risk.”
Challenges and future
In terms of risks investors in private markets should be aware of, liquidity is the main one for Cochrane. The second challenge with private credit is mainly in direct lending where “there’s been a lot of capital allocated”, which means that managers “have a lot to deploy and may not be able to be as selective when choosing which assets to invest in”.
Ross thinks the risk of defaults always looms in this space, despite default rates currently being low. “Ensuring suitable income coverage and overall investment quality is crucial. Partnering with entities providing adequate credit coverage helps mitigate default risks. The market’s potential shift towards refinancing in the coming years poses a challenge, necessitating a responsive credit market. We have avoided the secondaries market where price discovery remains an issue with so few readily available data points,” he says.
John notes that the current lack of emissions data availability in private credit markets also poses a challenge for investors with TCFD and net zero reporting requirements. “That said, we see standards of transparency evolving and private lenders in certain markets may have more influence than people think when engaging with borrowers on ESG practices, including disclosures given fewer financing alternatives,” he explains.
Cochrane thinks the asset class “looks likely to form an ever-growing portion of investors’ allocations”. In general, the European market has greater scope to grow, given that it’s “a far more banked market than the US although the US represents the largest opportunity set geographically”.
Hymans Robertson has also been monitoring the growth of the secondary market in private credit, which is far behind private equity in terms of its market maturity. Private equity, for example, has well over 100 dedicated private equity secondary funds, Cochrane reports, whereas there are fewer than 10 in private debt currently.
“There is more supply than demand and volumes have increased dramatically, especially in the UK, as corporate DB schemes are looking to sell their fund stakes. This is underpinning discounts to fund NAV. If the secondary private credit market does become more established in the future, there might be less penal treatment of investors trying to trade,” she states.
Ross says the future for private credit appears promising, offering attractive returns. “However, increased risk of default calls for robust due diligence before investment, with a focus on setting realistic expectations in these dynamic and potentially turbulent times,” he reports.
LPPI expects the market to continue to evolve and grow over the coming years, according to John. “Growth will be driven by a number of factors including continued bank retrenchment, sponsors/companies looking for more flexible solutions, and continued interest from investors looking to diversify away from traditional asset classes,” he says. John also cites estimates from investment data company Preqin that private credit assets under management “will grow by in excess of $1tn over the next three years”.
For more features like this, you can read the latest edition of the Private Markets Profile here.
—————
FREE bi-weekly newsletters
Subscribe to Room151 Newsletters
Follow us on LinkedIn
Follow us here
Monthly Online Treasury Briefing
Sign up here with a .gov.uk email address
Room151 Webinars
Visit the Room151 channel
