The term “going private” used to describe an enterprise’s effort to reduce the number of its stockholders in order to terminate its public company status. More recently, the term has also become a label for investors’ attempts to boost the yield in their fixed income allocations by tapping into private credit markets.
Private credit is offered to companies primarily from nonbank entities. As the name implies, it’s debt that’s not traded publicly. Also known as "direct lending," it’s a subset of the "alternative credit" universe and is one of the fastest-growing asset classes among institutional investors. It’s no wonder why. According to the Institute for Private Capital, these assets have historically been averaging an internal rate of return (IRR) of 8.1% across all strategies, with some schemes yielding an IRR as high as 14% over the past two decades.
Noninstitutional investors are generally excluded from private markets, but nowadays high-net-worth individuals, family offices and trusts are tapping into these high-yielding assets through funds offered by managers such as New York–based iCapital Network.
A suite of iCapital strategies, for instance, is included in the recently launched AssetMark Institutional investment platform, including the Owl Rock Opportunistic Fund, a limited partnership dedicated to direct lending.
The vast majority of capital in the alternative credit universe funds direct lending. Partners in the Owl Rock portfolio, for example, provide a diverse mix of credits, including secured and unsecured debt, mezzanine financings and other subordinated obligations senior to common equity.
Such senior loans generate most of their returns from coupons composed of a fixed credit spread above a reference rate such as Libor.
“We can’t speak about specific funds,” says Kunal Shah, managing director and head of private equity solutions at iCapital, “but generally speaking, corporate middle-market loan yields range from Libor (or Libor replacement when Libor is phased out) plus 500 to 900 basis points, depending on the size of the company.”
Bigger companies, says Shah, tend to pay a Libor premium of 500 to 600 bps while smaller concerns pay more.
As attractive as these payouts are, investors in private credit look for more than just yield. Since private loans aren’t marked to market, they tend to exhibit less volatility than publicly traded debt. That, coupled with short durations—investment horizons of just two or three years are common—make senior loan funds good diversifiers for a qualified purchaser’s fixed income allocation.
“Given the challenging yield environment, an allocation to private credit can be additive to a client’s portfolio,” says Zoe Brunson, senior vice president of investment strategies at AssetMark. “The mix of private credit and traditional fixed income is really dependent on the investor’s risk profile, not only their risk appetite but their capacity and propensity for risk.”
So, what kind of risk are we talking about? Private loans aren’t rated so apples-to-apples comparisons aren’t possible. Still, says iCapital’s Shah, “On the risk scale they would likely fall between the lower end of investment-grade bonds and the upper end of the high-yield bond market.”
Leverage often figures into the risk profile of direct lending schemes. Gross returns for unlevered senior loan funds tend to range between 6% and 10%. With leverage at the fund level, though, gross returns may climb as high as 15%. Leverage, of course, is a two-edged sword. It not only magnifies returns, it also exacerbates risk, so advisors and investors need to be mindful of the overall level and tenure of leverage lines.
Add this to the credit risk of the underlying portfolio and any idiosyncratic risks arising from the sponsor’s business model and you can readily see why private credit should be considered an augment and not a replacement for a conventional fixed income allocation.
“Using it as supplemental exposure to traditional fixed income to gain extra yield would provide diversification benefits to a portfolio,” says AssetMark’s Brunson. “We don’t think it should take the place of traditional fixed income since it can increase risk in the portfolio if it isn’t appropriately balanced.”
Advisors, says David McNatt, AssetMark’s senior vice president of investment strategy and development, need to consider some essential questions before recommending alternative credit strategies to their clients. Among these are:
- What is the investor’s goal?
- How can an alternative asset be added to achieve a better outcome?
- Why are these strategies being employed?
Of these, says McNatt, “the investor’s goal is paramount.”
Selection of a competent manager becomes critical once a decision is reached to employ alternative credit strategies. “As with any investment in the private markets,” says iCapital’s Shah, “it’s essential to invest with managers who are very experienced. It’s especially important in private credit because managers with more experience in the space often have more leverage to negotiate covenants and an advantageous loan structure.”
Brad Zigler is WealthManagement's alternative investments editor. Previously, he was the head of marketing, research and education for the Pacific Exchange's (now NYSE Arca) options market and the iShares complex of exchange traded funds.