Private Credit - Accessing Opportunities Outside of the Mainstream

This article was originally published in Pensions & Investments on 18 November.

Introduction

In a recent article I wrote for Man Institute, I suggested that the premium paid to investors in private credit relative to both private equity and public credit appears highly compelling. The elevated return premium currently commanded by private credit comes at a time when the asset class is in the process of evolving from one focused on ‘direct’ corporate cash flow lending to one that now encompasses a broad range of more specialised debt products, including: rescue lending, complex lending, consumer lending, real estate, structured finance and orphaned and special assets.

Private Credit – Growth in the Time of Covid-19

As institutional investors continue to struggle to meet their return targets in a low interest rate environment, we predict that allocations to private credit will increase at the expense of public markets. The moderation in private credit fundraising of recent years will reverse, with increased allocations establishing private credit as a legitimate and long-term component of institutional portfolios.

Figure 1. Private Debt Fundraising

Source: Preqin; as of end-2019.
Note: Excludes secondaries and funds-of-funds.

The 2020 coronavirus crisis was a catalyst for institutions to revisit their long-term asset allocation plans; one of the many shifts in client portfolios we saw was a broad move into private credit. As reported by Preqin, investor interest in this space has generally been directed towards the larger, more established managers in the North American market who focus on special situations and distressed strategies. It is striking, though, that this more developed (and competitive) segment of the market is yet to produce the kinds of opportunities that many of the multibillion-dollar funds raised in the wake of the pandemic claimed would materialise.

These larger funds are forced to look at the big-ticket end of the market as deployment in small deals does not move the needle for players of this size. According to Preqin, 2020 has seen 59 funds totalling USD67 billion in the US alone raised specifically to target opportunities associated with the coronavirus crisis – more than was raised by managers in the wake of the Great Financial Crisis. The competitive pressure of many vast funds looking to invest in the same areas of the same market is likely to erode away returns in this more generic and established segment of private credit.

Investors ought not, therefore, to ignore the less well-known sub-strategies within the private lending universe. We recommend that, rather than following the crowds into the most mainstream products, it makes sense at this point to look closely at more specialised strategies in order to maximise portfolio returns and take better advantage of the disruption caused by Covid-19. It is likely that returns in the more off-the-run and nascent section of the market, being less obvious and therefore less subject to competitive pressures, will outpace those of more generic strategies, in our view.

Private Credit Strategies in Focus

Lenders in the private credit space are increasingly stepping into areas that have been abandoned by traditional finance providers. This lending is typically to non-sponsor companies that have idiosyncratic characteristics, such as lending against a portfolio of esoteric assets. This might be anything from orphaned real estate to receivables, but what is key is that these specialists are able to take advantage of opportunities that others miss through their unique sourcing channels, their wealth of structuring expertise and their understanding of how to mitigate the unique risks of the sector in which they specialise.

One example is the growth of lenders focusing on companies that fall outside of the black-and-white model of cash flow direct lending. There is a developing universe of sector-specialist lenders focused on industries with high barriers to entry due to the specific technical or regulatory expertise required to make informed lending decisions. This phenomenon is particularly rife in the technology and health-care sectors, where assets are often intangible and highly complex, although even here it is possible to take a more asset-based lending approach than one might initially think.

Another opportunity that is worth evaluation is related to the growth of consumer credit needs as a result of the coronavirus crisis. As lockdowns hit, the utility of cash underwent a sudden and dramatic decrease. Consumers instead needed credit cards for online purchases. This spike in consumer credit applications coincided with a retrenchment of traditional providers in the space, as banks and finance companies hoarded capital in the expectation of the coming downturn. It has therefore been an opportune time for specialists to expand their market share in the sector and complete transactions with best-in-class operators, or to bid opportunistically on assets by employing their structuring expertise and granular asset underwriting capabilities to ensure that growth doesn’t come at the expense of credit quality.

Finally, another opportunity worth evaluating is real estate lending in Europe. This has historically been a difficult space for non-traditional operators to access – it is a less developed market than in the US and European banks continue to dominate lending here. However, the expectation is that these banks will have to rein in their activity as they deal with the economic fallout of coronavirus and, as such, specialised real estate lenders can step in and service the demand. First-movers in both commercial and residential spaces will reap benefits by providing capital where others have drawn back and will establish their place in a growing and fast-evolving market. For investors, the highly secured and well-covenanted European real estate market represents – in our view – a particularly compelling risk-reward proposal.

Conclusion

These are simply three examples across many that could be highlighted as offering attractive risk-reward profiles for those willing to explore outside of the mainstream of the private credit universe. To reiterate, specialised lenders have a unique opportunity to take advantage of a fragmented and poorly-understood market. They will need capital to do so, and investors who are up-to-speed on the more off-the-run opportunities will be able to access favourable returns through investing in areas that others are overlooking. While the massive funds raised by the biggest managers scrap over the largest segments of the private credit market, more nimble funds (and their investors) will be better served by looking at more specialised opportunities, potentially too small to tilt the needle for the multi-billion funds, but deeply compelling for those with the time and energy to put the work in.