Asset Managers See Further Potential in Private Credit Market

Amidst market uncertainty imposed by the pandemic and interest-rate hikes, portfolios have thrived in private credit; both CalSTRS and the CAIA Association hosted asset managers to discuss the asset class.

Updated with correction

The global private credit market is roughly $1.5 trillion and is pegged by some estimates to grow to $2.5 trillion by 2025, then potentially transform into a market worth between $5 trillion and $10 trillion over the next decade.

“If one would read the papers these days, you would think that direct-lending businesses is very new and a nascent asset class, and, in fact, it’s the complete opposite: This is an asset class that has been growing and developing for decades,” Mitch Goldstein, partner and co-head of credit at the Ares Management Corporation, said at a private credit educational session held for the California State Teachers Retirement System’s investment committee on February 8. “Over the last 30 to 40 years, there has been massive bank consolidation such that, today, there are 50% less banks in the country than there were in the ’80s, and by the way, that phenomenon is happening in Europe as well.”

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Goldstein shared an estimation that banks are now so concentrated that the five largest banks hold roughly 50% of all bank assets, while the 15 largest banks hold more than 70% of all bank assets.

“When the global financial crisis hit, the regulators got much more involved in what banks can and cannot do, and as these banks consolidated, they came to the conclusion that lending to small-to-medium[-sized] businesses was not profitable for them,” said Goldstein. He continued to say that big banks’ focus on volume created the necessity of lenders like Ares to meet “a massive supply-demand imbalance.”

“[The small-to-medium-sized enterprise space] is 30% of the U.S. economy. So again, there was this massive supply demand imbalance, and we, the direct lenders, started taking up the mantle of lending to this large and growing and, frankly, terrific industry,” Goldstein said. “The banks figured out it was a much better return for them if they lent through us to the small and medium companies in the country.”

Interest-Rate Hikes Work to Private Credit’s Benefit

Private credit has proven a resilient proposition for portfolios amidst a correlated move downward by both stocks and bonds in 2022.

“If you look at loss rates in private credit over time, not only are they not higher than loss rates in equivalent public-market credit, but they’re actually lower,” said Michael Patterson, managing director at HPS Investment Partners, to the CalSTRS Investment Committee. Patterson, who leads the firm’s direct lending platform, said that “the risk [between public debt and private debt] is very similar, though the returns are higher [in private debt].”

According to Oaktree Capital Management’s insights on credit from Armen Panossian, head of performing credit, and Danielle Poli, managing director, “Rising interest rates have made private debt with floating rates appealing to investors, and private credit has benefited from investor demand for floating-rate debt.”

Panossian and Poli note that “hung loan syndications are morphing into private deals. [While] banks are seeking to reduce risk on their balance sheets and are, thus, selling many leveraged-buyout-related loans in the private market at attractive prices.” In this macro-economic backdrop, “banks are unlikely to underwrite new LBOs until the banks’ balance sheets stabilize; [meaning] direct lenders are beginning to fill the void created in the market.”

As of December 31, 2022, Ares Capital Corporation’s $21.8 billion portfolio, consisted of 466 portfolio companies, backed by 222 different private equity sponsors; diversified across, issuer concentration, asset class, industry sector, and geographic representation.

“We invest in non-cyclical businesses. We get to pick and choose, we self-originate our assets, we pick what industries we want,” said Goldstein. “By choosing non-cyclical businesses, we tend to outperform in any risk-weighted metric that you can come to think of in the public markets.”

Describing the intricacies of the covenants and rates used in the loan origination process, Craig Packer, co-founder and senior managing director of Blue Owl Capital, said, “Because they’re floating-rate, there’s a base rate that are set off of an index in the leveraged loan market. The typical indices that we are all using used to be LIBOR. But LIBOR is in the process of being phased out and being replaced by an index called SOFR; typical terms would be SOFR plus the spread in today’s market.”

“One of the reasons why we’re all so excited about this current opportunity [in private credit], [is] that the higher rates have really benefited this asset class,” said Packer, articulating a similar point to that of the Oaktree analysts. “We’re lenders, you know; our upside is really limited. We don’t have upside. We’re making loans where we expect to get our principal back at maturity, at par. As a lender, we don’t have an opportunity to have our winner’s’ gains offset our losers. It’s very different than in the private equity business.”

Across The Pond: The European Market

The European portion of the investment vertical was the topic of a January 26 webinar hosted by the Chartered Alternative Investment Analyst Association, considering the growth of the industry and potential opportunities abroad. CAIA Association’s president and CEO, Bill Kelly, moderated the discussion.

“Private credit is a global asset class, with the U.S. being the largest and most matured part of the universe, accounting for approximately 60% of capital activity,” said Leo Fletcher-Smith, managing director at portfolio advisory firm Akisa. “The European side has grown pretty significantly and accounts for about 20-30% of the overall market.”

Fletcher-Smith said Akisa splits the category of private credit into six discernable categories: direct lending (general loans to senior and corporate borrowers); mezzanine lending; distressed and special situations; specialty finance; real assets credit; and real estate credit.

“Generally, a third is in direct lending, a third is in distressed and special situations, and a third is across everything else, in a broad brush,” Fletcher-Smith said, adding that the market has grown from about $100 billion in 2015 to about $400 billion over the last two years.

Jean Hsu, the managing investment director for private debt at the California Public Employees’ Retirement System, said allocating to European private credit comes with oblique currency risk that does not exist domestically, but she “thinks of it as a good diversifier.”

“Comparative-wise, I have less competitors over there,” said Hsu when asked why she explores European private credit. “In the U.S., you have direct lenders, CLOs, middle-market CLOs, and you have BDCs: They can buy loans, and they can buy the asset side at once. In Europe, you don’t have these. Under this supply-and-demand dynamic, in Europe, there will be less competition, less people competing against me, grabbing assets.”

CalPERS, as an asset owner of such grand size, could pursue private credit lending on a direct basis: “Direct lending is something we can do,” Hsu said. “You can do senior lending just like a bank, lending to a diversified pool of assets, and that’s something we can do internally. However, when you’re talking about individual assets and originating deals, we have to use extensions, and we use managers as our extension, because they have underwriters and originators. The funnel must be very big, so that you can have asset selection. At this stage, CalPERS relies on external managers to do the origination and underwriting for us. [Though], at the same time, we do [perform] co-investments alongside our managers.”

Discussing the opportunities that persist in the European segment of the market, panelist Lei Lei, co-head of European credit opportunities at asset manager Ninety One, pinpointed real estate as an asset class with heightened potential. Lei differs from both Fletcher-Smith and Hsu in that he is not an asset allocator, but a general partner, managing and leading investments in the €130 million Ninety One European Credit Opportunities Fund I.

“When you have a floating-rate loan, and your floating rate is zero, it’s very nice, because your cost-to-finance [ratio] is fairly low, but when your risk-free rate increases, then a lot of the businesses will have a potential issue from a liquidity perspective,” Lei said. “We are seeing a lot of interesting opportunities, where good-performing real estate businesses are raising capital in terms of being defensive, to ensure they’ve got sufficient liquidity to weather the next year or two, in terms of rates being higher than normal. And what we have seen even more of is businesses in the real estate and infrastructure sectors being opportunistic, because of market volatility and anticipated market dislocation, that there will be attractive opportunities for these businesses to make acquisitions at discounted levels.”

Due diligence is heightened in scope, when asset managers are dealing in the private credit segment, when compared to other portions of an institutional portfolio.

“At the core of how we navigate these markets is credit underwriting, which consists of picking the right companies, picking the right businesses which have tailwinds, not headwinds, and carrying out detailed underwriting and analysis,” Lei said. “That’s all that we can do as investors: to ensure that we take into account the uncertainty and over-laying that in terms of our underwriting.”