The Rise and Rise of Private Credit
December 3rd, 2023 | Article By Investment Team
What is Private Credit?
Private credit is a diverse set of investment strategies that encompass various positions in the capital structure and cater to different types of borrowers. This asset class covers a broad spectrum, ranging from conservative senior secured loans for well-established corporate entities to more risk-intensive junior unsecured credit, such as funding new construction projects. It extends further to loans collateralized by specialized assets like railcars and airplanes or tied to contractual revenue streams such as royalties and subscription services, and also includes distressed situations.
The Universe of Private Credit Strategies Has Been Expanding, Diversifying
Source: GoldmanSachs
The risk and return profiles of private credit investments differ across these various strategies. Senior secured loans, often provided to blue-chip corporations, are positioned at the lower end of the risk and return spectrum, offering stable yields. On the other hand, unsecured subordinated and mezzanine strategies involve financing further down the capital structure, providing higher yields to compensate for the additional credit risk. These strategies may also incorporate additional securities to participate in potential equity upside. Specialty and alternative credit opportunities, which cover a wide range of unique assets, offer varying risk and return profiles.
In addition to yielding cash returns, private credit strategies can involve components related to capital appreciation. Distressed and opportunistic strategies, for instance, focus on companies facing significant challenges. While these strategies present the highest dispersion of outcomes and may lack a yield component, they offer the potential for higher upside as the companies undergo restructuring.
The versatility of private credit allows for the construction of portfolios tailored to specific objectives. Investors can customize their exposure to different risk levels and return profiles based on their goals and risk tolerance. The array of private credit strategies provides flexibility, allowing investors to seek a balance between stable income, potential capital appreciation, and their risk preferences. Overall, private credit serves as a dynamic and adaptable asset class that can be structured to meet the diverse needs and preferences of individual investors.
The Rise and Rise of Private Credit in 2023
The year 2023 has seen the fast rise of private credit as an asset type with attractive return/risk ratio, attributed to the hunting-for-yield investors and favorable conditions in both the economics indices and the generally positive credit markets. As market draws a closer conclusion that the Fed has its job done and economics softening, what next for the private credit are the right questions to ask – particularly if corporate earnings start to reflect consumer’s spending cut and the higher-for-longer interest rate starts to bite. Will credit qualify start to deteriorate in the spectrum of credit products and and will it begin from the relatively higher-risk private credit space?
Size of distressed debt marked up +400% in 2022
Value of US Corporate Bonds and Loans at Distressed Levels
What May Affect the Quality of Private Credit?
An Economic Soft-Landing
US economy has remained surprisingly resilient during the aggressive rate hike in recent decade. Moving on to 2024, after the erosion of excess savings from Covid by inflation, Consumers may soon start tightening their spending, which may first affect corporate earnings, although it may only start to be read from the numbers after one or two quarters. Private credit, being sensitive to economic cycles, could experience challenges as businesses face headwinds. It becomes crucial for investors and lenders to assess the resilience of the private credit portfolio to economic downturns.
Higher-For-Longer Interest Rates may hurt Balance Sheet
One of the most direct impacts of higher interest rates is the increase in interest expenses. Corporations with variable-rate debt or those seeking new financing in a higher interest rate environment will face higher borrowing costs. This can lead to a rise in interest payments on existing debt, affecting the bottom line and potentially squeezing profit margins. Corporations with a significant amount of debt coming due for refinancing may face challenges and see their free cashflow and working capital eradicated; worse, higher interest rates will lead to the reduction of their asset value; further deteriorate their balance sheet resilience.
A sustained period of higher interest rates can impact the cost of debt for companies. While private credit often involves floating-rate structures that can provide a degree of protection, increased interest rates may lead to challenges for highly leveraged businesses. Investors need to monitor how rising rates impact the creditworthiness of borrowers.
The Risky Global Geopolitical Environment
The conflict in the Middle East; the frontlines in Ukraine, this world has not seen such fragile geopolitical environment like this. If regional conflicts accelerate, it may well spill over to effect global geopolitical risk map and the broad economic production worldwide. Escalation of regional conflicts can indeed have spillover effects, affecting the broader global geopolitical risk map. Geopolitical events in one region can impact alliances, trade relationships, and diplomatic ties, contributing to a more interconnected and potentially fragile global landscape. Geopolitical tensions and conflicts have the potential to disrupt global economic production and trade. Supply chain disruptions, changes in investor sentiment, and increased uncertainty can affect businesses and markets worldwide. The energy sector, in particular, is often sensitive to geopolitical events in the Middle East.
Disclaimer:
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance.
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.
An investment strategy focused primarily on privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity. An investment in such securities or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price. The value of most bond funds and credit instruments are impacted by changes in interest rates; bond prices generally move in the opposite direction of interest rates. Investing in lower-rated or high yield debt securities (“junk bonds”) involve greater credit risk, including the possibility of default, which could result in loss of principal – a risk that may be heightened in a slowing economy. Investments in derivatives involve costs and create economic leverage, which may result in significant volatility and cause the fund to participate in losses (as well as gains) that significantly exceed the fund’s initial investment in such derivative. Reduced liquidity will have an adverse impact on such securities’ value and on a portfolio’s ability to sell such securities when necessary to meet the portfolio’s liquidity needs or in response to a specific market event. Diversification does not guarantee a profit or protect against a loss.