By Kelvin Lee, Alonso Munoz
Let’s take a step back for a moment and review how a traditional bank works. In general, a bank receives money through customer deposits and ultimately lends those deposits out to customers for business and household purposes (such as mortgages, auto loans, real estate loans, revolving credit, etc.). The difference between what they owe in deposits and what they collect from interest on their loans is considered profit. Unless you’re really bad at underwriting your loans (RIP to SVB and First Republic), it’s a very lucrative business.
In the case of private credit, and credit funds specifically, let’s replace the “bank” with a “fund manager” and “customer deposits” with “investor capital.” Bam, you have a private credit fund. Essentially, private credit covers a group of private loans that are financed by investors. For example, let’s pretend you send money to a big private credit manager like Apollo or KKR to invest. Their knowledgeable analyst teams conduct due diligence, risk management, etc., on a capital-needing company, let’s say Cisco for example, and then lend them your money. Cisco pays interest on that loan, and that interest ultimately flows to investors. Because Cisco is, in this scenario, considered a good investment by the fund manager, you don’t worry too much about your principal and celebrate all your new income. Sounds a lot like a bond, right? Well, it pretty much is, except these private loans aren’t generally traded on public markets, and the companies needing financing aren’t usually public either. In its simplest form, private credit is direct lending by non-bank institutions.
The Good:
If you have watched any financial news lately, you have probably heard of private credit and its growing popularity. So why do we like it? (Besides the fact that everyone else does) First, as investors, private credit offers high yields that aren’t as interest rate-sensitive compared to traditional fixed income. Typically, these private credit loans are floating rate and short duration. That means the interest on these loans adjusts with market rates plus some type of spread. So, if interest rates go to 5%, and a loan has a 300-bps spread on it, we’re now getting an 8% yield. Of course, vice versa is true; if rates go down to 3%, that loan would have a 6% yield, but at that point, the total interest on the loan would be competitive with other income vehicles. And 300bps is typically on the lower end. Some loans have a spread of 700-bps above rates. In general, we’re getting good returns without daily market and rate volatility. We like to see private credit as not just an alternative allocation to portfolios, but as a fixed income complement to traditional corporates or treasuries.
On the other hand, for debtors, private credit is filling a liquidity void left in the market. The impact of higher rates has caused banks to tighten their lending capacity, and businesses have struggled to secure financing. Instead of going to a venture capital (VC) or private equity (PE) firm, which would likely require an equity stake, firms are looking to private credit as a solution for their capital needs. It’s a win-win for both sides. Companies get their financing, and private credit funds enjoy solid returns. Private credit is ultimately de-banking the lending space and taking a burden off the “too big to fail” suspension bridge we call our banking institutions. Demand for lending alternatives is expanding fast, and any lending gaps from banking regulations are going to be filled by private credit.
The Bad:
Given the “private” nature of private credit, it’s not the most liquid market for investors. Private credit exposure is generally accessed through BDCs (business development companies) or closed-end interval funds which have quarterly redemption windows and potential lock-up requirements. Also, private credit funds aren’t cheap when compared to buying bonds or an ETF. Management fees usually start at 150bps, and some funds even have performance fees built in, driving costs further. While it’s important to find a reputable manager to select the companies and structure the loans, we caution on high fees regardless of the investment class.
While private credit funds aren’t sensitive to interest rate risk, they still are affected by the broader macro-environment. The borrowers in these funds are ultimately businesses, and if they default on their loans, whether from high refinancing rates or a slowdown in demand, that income to the fund goes away. Since some private credit managers target potentially “riskier” businesses, default risk is a big concern. Regarding the macro environment, it’s also important to look at the broader headwinds for private credit: increased competition. Private credit has grown exponentially over the last few years, increasing from a niche investment category for institutional investors to now a nearly $2 trillion market. That boost in investor demand means more competition as more dollars chase the same loans. As more shops like Ares, which recently launched a $20 Billion fund, join the market, borrowers can demand lower rates, potentially lowering the yield profile of private credit funds. The same goes for banks if lending standards loosen because of market dynamics or monetary policy. Future borrowers may consider going back to cheaper financing solutions from banks instead of private credit funds.
Outlook:
As the private credit market continues its explosive growth, and the environment becomes more competitive, we’re still optimistic about private credit. We think large and middle-market firms will still use private credit funds as they explore options away from big banks. With private credit funds, borrowers get reliability in execution, confidentiality, speed, and flexibility. They don’t have to deal with syndication or redundant banking regulations. However, increased regulations may find their way to private credit in future years given its popularity. Currently, the market is subject to minimal, indirect oversight and isn’t as transparent to investors as other public investments. The increase in lending competition also incentivizes private credit funds to loosen their due diligence and covenants for riskier companies to gain market share. We wouldn’t be surprised to see increased scrutiny on private credit by the US Senate Committee on Banking this year.
To contact the author of this story:
Kelvin Lee at kelvin@hamiltoncapllc.com
To contact the editor responsible for this story:
Alonso Munoz at alonso@hamiltoncapllc.com
