Private credit’s special sauce

Good morning. That artificial intelligence rush you’re hearing about five times a day? Even that isn’t offsetting the weak global economy and China’s disappointing recovery, Taiwan Semiconductor’s chief executive said yesterday. Chip stocks fell 4 per cent, including high-flying Nvidia, down 3.3 per cent. AI, we are told, may be more profound than electricity or fire, but nothing beats the business cycle. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Private credit’s secret sauce

It is a glorious moment for any investment when it grows up and becomes its own asset class. It doesn’t happen often. There was a time when a proper institutional portfolio consisted of blue-chip equities, sovereign debt and maybe high-grade corporate bonds. In the 1980s and 90s, junk bonds became high-yield bonds and took a seat at the institutional table. Private equity became a standard asset class for institutional investors soon thereafter, and has never looked back. In both cases, the newly-christened asset classes won their places at the table by offering investors something special — a “special sauce” that helps make institutional portfolios better than the sum of their parts.

The glorious bit is that, once an investment has ascended to asset class status, money is basically guaranteed to flow into it. There is a huge amount of savings in the world — possibly too much. It has to go somewhere. Institutional asset managers are conservative, and hold dear the dogmas of diversification, efficient frontiers and Sharpe ratios. Once a new asset class is on the menu, institutions will order it.

Private credit, if it is not already its own asset class, is well on its way to becoming one. This chart shows the wild growth of money raised and deployed by private credit funds since the turn of the century:

What is private credit’s “special sauce”? Private credit’s returns vary a lot by subsector: direct lending for leveraged buyouts, for companies in distress or special situations, asset-secured lending, and so on. And, of course, private credit is private. There is no nice, smooth index of industry returns. This makes it a bit hard to make direct return comparisons to high-yield bonds, the nearest fully established asset class. Goldman Sachs takes a shot at a clean comparison in the table below. The cells are colour-coded to show performance rank for each year (sorry if you are reading this on a mobile and have to squint like crazy):

(“Leveraged loans” pretty much means syndicated buyout debt; “BDCs” are business development companies, which are publicly traded entities that lend to small and midsized private companies; “private debt” is non-syndicated buyout lending.)

Even if aggregate returns are hard to tot up, the pitch from the industry is clear enough. The promise of private credit is that for a loan to a borrower of a given creditworthiness, it can get returns that are either a bit better than, or less volatile than, or at the very least uncorrelated to, other forms of lending such as high-yield bonds. So the institutional investor will receive either better risk-adjusted returns or, at the very least, diversification benefits. 

How does private credit achieve this? Private debt managers cite four broad factors:

1. There are a lot of borrowers who, for one reason or another, aren’t a tidy fit for the bond or syndicated loan markets. Maybe their business is poorly understood, or complicated, or they don’t have a credit rating, or don’t want to reveal a lot of information to the whole world in an investor roadshow. Maybe they care a lot about the certainty of pricing and execution. These companies will pay more for capital than a similarly risky company that is a good fit for the bond and syndication markets.

2. Private debt markets have more restrictive, more customised contracts than the bond and syndicated loan markets do, so private lenders are less likely to get, for example, “J Screwed” by a shifty borrower who moves assets to a subsidiary and then borrows more money against them.

3. Private debt is not marked to market, so price volatility is lower or, if you prefer, hidden.

4. The bilateral relationship between a single lender and a single borrower means that, if the borrower should run into trouble, there is a better chance of an effective workout than if the debt was owned by multiple parties — particularly parties who may have bought the debt at distressed prices. Recoveries are higher, in other words. Many lenders also do repeat business with borrowers, incentivising them to push through any short-term volatility.

Sensitive readers will have noticed that some version of these four factors applies to private equity, as well. Private equity, though, has two other sources of risk-adjusted or uncorrelated return. One is adding a ton of leverage to a target company to increase return on equity; private credit is leverage, so there is no analogy. The other factor is that private equity claims to make operational improvements to target companies. But because that factor is (in Unhedged’s view) mostly just a posture, its absence is probably good news.

As sources of superior risk-adjusted or uncorrelated return, the four factors make sense to us. Basically, private credit funds are saying, “we are smart and hard-working and do the tricky stuff, and so we can earn a little more at a lower level of risk”. Fair enough. The question investors must ask is whether the extra risk-adjusted performance is greater or less than the fees these clever, hard-working people charge. This will be particularly true as the asset class continues to grow, and there is more competition among lenders.

The history of private equity is instructive here. That industry’s returns have drifted closer and closer to those of public equity markets as they have paid higher and higher multiples for the businesses they have bought. It could be argued — and has been argued here — that basically all the extra return private equity earns is now absorbed by fees. The principal advantage the industry enjoys over public equity markets is the absence of mark-to-market. It is easy to imagine private credit heading in that direction over time. 

It is important to emphasise, however, that even if private credit’s risk-adjusted returns become hard to distinguish from public alternatives, this will not matter much to the private credit industry. Once an asset class, always an asset class. Institutional investors will need somewhere to write multibillion-dollar cheques to. So long as big funds can offer the appearance of diversification and avoid big losses, some of those cheques will be written to private credit, long after the special sauce has lost its flavour.

Private credit and systemic risk

Does the move from public debt markets to private credit lower systemic risk?

Here’s the case that it does. Banks are systemically vital but intrinsically fragile. Private credit, as non-bank lending, is offering banklike services using funds from deep-pocketed, sophisticated investors, rather than flighty depositors, and without a side gig as critical financial infrastructure. Many private credit funds enjoy long lock-up periods, hold loans to maturity and avoid short-term debt financing. That private credit investments are less liquid is a big help in choppy markets, which might induce forced selling elsewhere. In sum, shifting some lending activity away from banks to slow-moving private credit reduces overall systemic risk, which often stems from sudden-stop liquidity crunches.

Recent experience lends some weight to this argument. In 2022, as rising rates largely shut down syndicated loan origination — and saddled banks with lossmaking hung loans — direct lenders kept on lending. During that episode, private credit “provided a valve”, says Christina Padgett, head of leveraged finance research at Moody’s.

This risk-reducing case doesn’t allay all fears, for three reasons. One is that private credit is untested. At its current scale, the sector has not gone through a proper credit cycle (Covid surely doesn’t count). Unforeseen vulnerabilities may emerge in a period of real stress. That possibility is made more worrisome by the second reason: opacity. Data on things such as sector exposure concentrations, trends in borrower defaults, or how private lenders handle workouts are not readily available.

Third is that direct lenders may face an asset-liability mismatch, one senior private credit investor pointed out to us. Direct lenders’ assets typically have longer-dated maturities, say five to seven years, whereas the leverage facilities they draw on to enhance returns, usually from banks, tend to be shorter in duration. There is therefore “some risk of getting a margin call”, the investor noted, though they stressed this risk doesn’t look horribly scary.

All told, we suspect the move to private credit does reduce systemic risk, or at least doesn’t add to it, but the information void makes us nervous. Padgett puts it bluntly: “Not knowing isn’t good.” (Ethan Wu)

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