The 2008 credit crisis was a game changer for the Private Credit markets. It ravaged the balance sheets of banks and what ensued, massively curtailed banks’ capacity to lend to small and medium-sized companies. As per the new capital requirements under Basel III, banks were asked to set aside higher amounts of money every time they forwarded loans, especially to small and medium-sized companies, thereby forcing them to reduce the size of their loan books.
Fast forward a couple of years, when the global economy started to recover from this crisis, demand for fresh capital started growing rapidly, which included sizeable demand from small and mid-sized companies. As banks were unable to service all such loans, asset managers started taking advantage of this shortfall by providing debt financing solutions which were backed by their (the asset manager’s) clients.
As a result, we have seen a gradual emergence of the Private Credit market in Europe in recent times, something that was mainly prevalent in the US. The chart below provides an overview of the reducing reliance on traditional banks for corporate funding.
WHAT IS PRIVATE CREDIT?
Private Credit is debt issued by a company which is not freely traded on organised markets. These are typically small and medium sized companies (whose debt is typically unrated or, if it were, would be below investment grade) which do not have access to traditional financing opportunities such as bond issues and/or bank loans.
Private debt is perceived as generating equity-like returns along with risk protection akin to traditional bonds. A large portion of the returns is made up from illiquidity premia that has been discussed later in the paper. Potential returns expected from this asset class can range from LIBOR + 400bsp p.a. to LIBOR + 1500bsp p.a. depending on the credit worthiness, the current circumstances of the debt issuer, the seniority of debt chosen to invest in the issuer’s capital structure and any leverage employed within the selected investment manager fund.
The predominant risk that this investment carries, much like traditional bonds, is the risk of default from the company issuing the debt. A default occurs when the issuing company fails to make a coupon or principal payment to the investor. Other risks associated with Private Credit are akin to typical fixed income instruments such as prepayment risks, regulatory risks, credit jurisdiction and market dynamics among others. However, since this debt is a private placement between the issuer (the company) and the lender (the Private Credit fund), the lender can negotiate a strong set of covenants that the issuer will need to adhere to before investing in the company.
Capital Structures and Investment Types
The ‘seniority of debt’ normally decides the perceived levels or risks and returns that an investor can expect from investing in Private Credit. There are multiple debt levels that investors can choose from, each of which have priorities over claims on the company’s assets.
The chart below depicts a typical capital structure for any given organisation along with the risk and return trade-off for each level of debt.
The illiquidity premium is the additional return an investor demands for committing to an investment that cannot easily be sold to another investor or simply put, converted to cash. Since Private Credit is a private placement with investments lasting roughly five to seven years, the illiquidity premium forms a vital source of expected returns for the investor. With yields at extremely low levels (especially in the US and Europe), the hunt for yields has entered the illiquidity premia territory. An analysis by Pemberton, using the Ang Study method suggests that for an average investment horizon of 5 years in an illiquid asset, the illiquidity premium amounts to 4.3% p.a. And as noted in this paper that Private Credit investments range between five and seven years, a 4.3% illiquidity premium in a low yield environment could make up a majority portion of an investor’s expected returns.
Today’s investment landscape has changed as excess liquidity has heightened the correlation between historically uncorrelated assets. Investors are now looking for new asset classes which carry a good diversification potential. Banks continue to find it increasingly difficult to lend at levels they did prior to the financial crisis (and with regulations now in place, going back to the old days looks unlikely). Further, most asset classes have valuations at all-time high levels and yields continue to be depressed due to actions such as Quantitative Easing. Private Credit, on the other hand, is well protected from all of this with interest payments linked to short term rates (i.e. payments increase as short term interest rates increase). And hence, it has emerged as one of the credible asset classes for future investing such as infrastructure and energy.
For pension schemes, investing in Private Credit can be a strong option to consider. Periodic coupon payments from such investments which last typically five to seven years, could help pension scheme trustees in better Asset- Liability management as cash-flows can be better matched.
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