Unveiling the Secret Recipe that is Revolutionizing Private Credit! You Won’t Believe What’s Inside!

Good morning. That rush of AI you feel about five times a day? Even that doesn’t make up for the weak global economy and disappointing recovery in China, Taiwan Semiconductor chief executive said said yesterday. Chip stocks fell 4%, including flagship Nvidia, down 3.3%. artificial intelligence, we are told, it may be deeper than electricity or fire, but nothing beats the business cycle. Email us: robert.armstrong@ft.com AND ethan.wu@ft.com.

The secret sauce of private credit

It’s a glorious time for any investment as it grows into its own asset class. It doesn’t happen often. There was a time when an adequate institutional portfolio consisted of blue-chip stocks, sovereign debt and perhaps top-tier corporate bonds. In the 1980s and 1990s, junk bonds became high yield bonds and took their seats at the institutional table. Private equity soon became a standard asset class for institutional investors and has never looked back. Either way, the newly christened asset classes have taken their place at the table by offering investors something special, a “special sauce” that helps make institutional portfolios better than the sum of their parts.

The glorious part is, once an investment has risen to asset class status, money is basically guaranteed to flow into it. There is a huge amount of savings in the world, maybe too much. It has to go somewhere. Institutional asset managers are conservative and cherish the tenets of diversification, efficient frontiers and Sharpe ratios. Once a new asset class is on the menu, institutions will order it.

Private credit, if it isn’t already its asset class, is well on its way to becoming one. This graph shows the wild growth in money raised and employed by private credit funds since the turn of the century:

What is the “special sauce” of private credit? Private credit yields vary widely by sub-sector: direct lending for leveraged buyouts, for companies in distress or special situations, asset-backed lending, and so on. And, of course, private credit is private. There is no nice, regular index of industry performance. This makes it a bit difficult to make a direct comparison of yields with high yield bonds, the closest fully established asset class. Goldman Sachs makes a stark comparison in the table below. The cells are color-coded to show the performance ranking for each year (sorry if you’re reading this on a mobile and have to squint like crazy):

(“Leveraged loans” basically means syndicated buyout debt; “BDCs” are business development companies, which are publicly traded entities that lend to small and medium-sized private companies; “private debt” is non-syndicated buyout loan.)

While aggregate returns are difficult to add up, the tone of the sector is quite clear. The promise of private credit is that for a loan to a borrower of a given credit rating, it can get slightly better or less volatile yields than other forms of lending, such as high-yield, or at least uncorrelated bonds. Thus the institutional investor will receive better risk-adjusted returns or, at the very least, diversification benefits.

How does private credit achieve this? Private debt managers cite four main factors:

1. There are many borrowers who, for one reason or another, are not well suited to the bond or syndicated loan markets. Maybe their business is little known, or complicated, or they don’t have a credit rating, or they don’t want to reveal much information to the world at an investor roadshow. Maybe they care a lot about price certainty and execution. These companies will pay more for equity than a similarly risky company that is well suited to the bond and syndicate markets.

2. Private debt markets have tighter and more personalized contracts than bond and syndicated loan markets, so private lenders are less likely to get, for example,”J screwedby an elusive borrower who transfers assets to a branch and then borrows more money against them.

3. Private debt is not mark to market, so price volatility is lower or, if you prefer, hidden.

4. The two-way relationship between a single lender and a single borrower means that, should the borrower ever get into trouble, there is a greater chance of an effective redemption than if the debt were owned by multiple parties, particularly parties that may have bought the debt at bargain prices. Recoveries are higher, in other words. Many lenders also do repeat business with borrowers, incentivizing them to weather any short-term volatility.

Sensitive readers will have noticed that some version of these four factors also apply to private equity. Private equity, however, has two other sources of risk-adjusted or uncorrelated returns. One is adding a ton of leverage to a target company to increase return on equity; private credit AND leverage, so there is no analogy. The other factor is that private equity claims to make operational improvements to the target companies. But since that factor is (from Unhedged’s perspective) mostly just a posture, its absence is probably good news.

As sources of superior risk-adjusted or uncorrelated returns, the four factors make sense to us. Basically, private loan funds say, “we’re smart and hardworking and we do the complicated stuff, so we can make a little bit more at a lower level of risk.” Fair enough. The question investors need to ask is whether the additional risk-adjusted performance is greater or less than the fees these smart and hard-working people charge. This will be especially true as the asset class continues to grow and there is more competition among lenders.

The history of private equity is instructive here. That sector’s returns have moved ever closer to those of public stock markets as they have paid higher and higher multiples for the assets they have bought. One could argue – and it was discussed Here – that virtually all the extra returns earned by private equity are now absorbed by fees. The main advantage the sector enjoys over public equity markets is the absence of mark-to-market. It is easy to imagine private credit moving in that direction over time.

Importantly, however, even if risk-adjusted returns on private credit become difficult to distinguish from public alternatives, this will not matter much for the private lending industry. Once an asset class, always an asset class. Institutional investors will need a place to write multibillion-dollar checks. As long as the big funds can offer the appearance of diversification and avoid big losses, some of those checks will be in private credit, long after the special sauce has lost its flavor.

Private credit and systemic risk

Does the shift from public debt markets to private credit reduce systemic risk?

Here is the case that it does. Banks are systemically viable but inherently fragile. Private credit, as non-bank lending, offers banking-like services using funds from sophisticated and wealthy investors, rather than fickle depositors, and without a side gig like critical financial infrastructure. Many private loan funds enjoy long lock-up periods, hold loans to maturity and avoid short-term debt financing. The fact that private credit investments are less liquid is of great help in volatile markets, which could lead to forced selling elsewhere. In sum, shifting some lending from banks to slow private lending reduces overall systemic risk, which often arises from sudden liquidity crises.

Recent experience gives some weight to this argument. In 2022, as rate hikes largely stalled syndicated loan creation and burdened banks suspended loans at a loss — direct lenders continued to lend. During that episode, private credit “provided a valve,” says Christina Padgett, head of financial finance research at Moody’s.

This case of risk reduction does not allay all fears, for three reasons. One is that private credit is not tested. At its current scale, the industry hasn’t been through a proper credit cycle (Covid certainly doesn’t count). Unforeseen vulnerabilities can emerge in a time of real stress. This possibility is made more worrying by the second reason: opaqueness. Data on things like industry exposure concentrations, trends in borrower delinquencies, or how private lenders handle rescheduling isn’t readily available.

Third, direct lenders may face an asset-liability mismatch, a senior private credit investor pointed out. The assets of direct lenders typically have longer maturities, say five to seven years, while the leverage structures they draw on to enhance returns, usually from banks, tend to have shorter durations. So there is “some risk of getting a margin call,” the investor noted, although he stressed that risk doesn’t sound terribly scary.

All in all, we suspect that the move to private credit reduces systemic risk, or at least doesn’t add it, but the information vacuum makes us nervous. Padgett puts it bluntly: “Not knowing is not good.” (Ethan Wu)

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