Nature abhors a vacuum. After the financial crisis of 2008-2009, banks stopped lending to medium-sized, often private companies, which were also unable to tap into the bond market. Under pressure from regulators, traditional lenders have had to reduce their risk profile.
Then companies like Apollo Global Management, Ares Management and Jefferies Financial Group stepped in to provide these loans to these abandoned entities. And they did so at attractive rates (to the lender) ranging from 5% to 15%, depending on credit quality and position in the capital structure. “We believe this market is dwarfing the alternatives market,” Apollo CEO Marc Rowan said at an investor conference last fall. Private credit is also used for real estate and distressed businesses.
Many asset allocators agree and get on board. Total private debt assets under management (with mostly institutions investing in these efforts) reached approximately $1.2 trillion. That’s after a decade of average annual growth of 13.5%, per research firm Preqin.
Hmmm, borrowers who can’t get a bank loan? Does dealing with these people seem risky? Moody’s Investors Service think it is. The rating agency warned in a recent report that private debt could collapse, criticizing it for its lack of disclosure, its concentration among a few large fund managers and its quality as a low-end creditor.
“The rising tide of leverage sweeping across a less regulated ‘grey zone’ carries systemic risks,” the report warns. “Risks that escape the spotlight of public investors and regulators can be difficult to quantify, even if they have broader economic consequences.”
Good okay. But these loans did not have big problems. And they have been tested by fire. In the horrible pandemic-damaged second quarter of 2020, defaults on U.S. private loans peaked at 8.1%, according to the Proskauer Private Credit Default Index. By the third quarter of last year, that figure had fallen to 1.5%.
Indeed, Molly Murphy, CIO of Orange County Employees Retirement System (OCERS), which holds 4.4% of its approximately $22 billion portfolio in private credit, said, “Private credit has held up well for us in March 2020.”
These loans generally have variable rate coupons and short maturities (terms of five to seven years, amortized in three years on average). Loans are most often secured first lien with a first lien on all assets of the borrower. Many loans have strict covenants and are subject to constant scrutiny, said David Sifford, private sustainable infrastructure manager at TortoiseEcofin, an investment firm focused on clean energy. He said, “Nothing should come as a surprise” with direct lending, as it’s also called.
Admittedly, there is a significant downside to private credit beyond risk: a lack of liquidity. Other major asset classes do not have this problem. Leveraged bank loans are bundled into collateralized loan obligations (CLOs), which large investors can buy and sell. But if an investor has to bail out a private loan, so be it. In other words, investors are locked in for the duration, although some private credit limited partnerships only last four years, due to the short loan terms, which is not really a hardship.
Avoiding private debt is ignoring a great opportunity, according to an article by Russell Investments. The United States has more than 17,000 private companies with annual revenues exceeding $100 million, compared to 2,600 public companies generating the same revenues. “By this measure, investors who only allocate to public markets limit their opportunities to only 15% of the largest companies in the United States,” the report says.
Among institutional investors, particularly pension programs, direct lending has found favor. The New York State Joint Retirement Fund, Pennsylvania Public School Employees Retirement System (PSERS) and Los Angeles Fire and Police Pensions (LAFPP) are among those with positions in the asset.
OCERS’ Murphy said his fund had “strong private debt performance in 2021 in the mid-teens with a three-year high-single-digit net performance.”
Globally, private debt assets will more than double to $2.7 trillion by 2026, Preqin predicted. For some reason, perhaps low interest rates elsewhere, the number of private debt transactions has slowed but increased in size. Preqin predicts that the US market, which now accounts for more than 60% of private debt assets, will continue to dominate the sector.
In fact, underfunded pensions are an ideal area for private debt investments, a document from the Chartered Association of Alternative Investment Analysts (CAIA) asserted. It’s not too late for them to “reap the benefits of private direct lending strategies,” the document states. The report quotes New York Yankees great and social commentator Yogi Berra: “When you come to a fork in the road, take it.
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Tags: 2022 Alternative Investments Special Report, Apollo, Ares, CAIA, direct lending, Jeffries, liquidity, Moody’s, New York State Joint Retirement Fund, Orange County Employees Retirement System, Preqin, Private credit, private debt, Proskauer, TortoiseEcofin