Last Thursday I had the privilege of moderating a panel discussion for AIMA (Alternative Investment Management Association) focused on the growing private credit sector. Together with experts in this field, we provided insight into why the private credit sector continues to comprise an important allocation for institutional investors and for private client investors as well.
Prequin (global leader in alternative assets consulting) recently stated that the size of the private credit market at the start of 2023 was approximately $1.4 billion (USD), compared with $875 million in 2020 and is estimated to grow to $2.3 trillion by 2027. Our very own Canada Pension Plan (CPP) has 9% of their portfolio in private credit. Interestingly, alternatives accounts for 67% in the portfolio currently, up from 64% in 2022.
During our one hour discussion, which can be found here, we spoke at length about how wealth advisors and investors can consider the private credit market as an important component in a properly diversified portfolio. A few topics of importance follow…
- Why the private credit market is in place: if we consider bank financing more like ‘working capital’ and private credit as ‘growth capital’, it leads one to understand why growing companies require both types of funding. Private credit lenders charge a higher rate as they are more flexible in the terms of their offerings than typical bank lenders, often working alongside their borrowers as board members or consultants and helping them to reach their shorter and longer term objectives. With higher rates earned, investors thereby earn higher rates.
- Private credit vs public credit: both types of investments offer their own risk and reward expectations. Because private credit is less liquid, whether in a few months or through the full term of a stated number of years, the illiquid nature of private credit (and private market investments generally) commands a premium return for investors (referred to as the illiquidity premium). Liquid markets will also be more volatile by nature of daily liquidity, and which is demonstrated by the Canadian Corporate Bond Index which is down approximately 9% since the start of 2022. Both can serve an important role in an investment portfolio, each with different characteristics and expectations.
- Inflation protection: unlike a liquid bond (government bonds more so than corporate bonds), private loans do not experience draw downs in capital value due to rising interest rates. Typically, private loans are structured with shorter terms to maturity and thereby as loans mature, new money can be sent out at higher/prevailing interest rates (this applies to fixed rate loans). Loans that are structured with variable rates establish a rate payable above a stated bank rate and with a floor in place as rates decline. An example of this type of variable rate loan is ‘5.0% plus SOFR (secured overnight financing rate)’.
- Due diligence: as with all investments, appropriate due diligence must be conducted prior to and during the lifetime of an investment. Private credit is no different – there are numerous aspects to understand and evaluate prior to making an investment in private credit, including but not limited to collateral protection, terms and covenants of the loans, liquidity parameters, manager history and objectives in workout scenarios, transparency, costs, manager alignment, borrower quality, diversity of loan book, etc etc. This is a market that is best invested in by way of a professionally managed fund rather than individual loans.
An investment in private credit can offer increased returns, decreased risks and reliable income which is protected from the ravages of inflation. It’s important to ensure that your private credit partners have a history of success in their specific niche and that their ability to navigate through tougher economic environments is proven. We continue to believe, as does the CPP and many others, that an investment in private credit can add meaningful value in an investment portfolio.