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Why Private Credit Is the Alternative Asset Class Everyone Covets

Investors tend to appreciate private credit for delivering current income and lower volatility. In a world of higher interest rates, it also gives them the opportunity to achieve higher yields.

In an environment in which debt has become harder for businesses to access from banks, financial advisors want to allocate more to private credit investment vehicles.

A survey of 260 financial advisors conducted by Mercer Investments and CAIS last fall found that 98% of respondents were already investing in private debt. Close to half (45%) were allocating between 6% and 20% of their clients’ portfolios to the asset class. Sixty-eight percent planned to increase their allocations to private credit over the next 12 months. Another 23% planned to maintain their current allocations.

While private equity continues to be the top choice for advisors in building up their clients’ allocations to alternatives, private credit has almost caught up, noted Gregg Sommer, partner and U.S. financial intermediaries leader with Mercer Investments.

“Private credit continues to gain momentum,” he said. “It’s obviously an income-producing asset class, and when we are thinking about wealth management, some of the underlying clients need income. Having that income aspect is going to continue to be highlighted and really might be even more important in the future.”

Forty-one percent of advisors surveyed for the CAIS/Mercer study targeted private credit investments to provide supplemental income to their clients.

But with the Fed’s key interest rate target now in the 5% range and many funds focused on providing floating-rate loans, private credit currently offers attractive returns, according to Tim Clarke, lead private equity analyst with capital markets data provider PitchBook. He noted while most private credit funds are currently paying distributions of approximately 10%, the best way to gauge total returns is to look at the broader syndicated loan market, where trading happens on an everyday basis. That market delivered a return of 13.5% in 2023, Clarke said, with returns in the first two months of 2024 trending around 11.0% to 12.0%.

“These are equity-like returns, and you are getting them now. You are not waiting until assets are sold,” he said.

An investor survey completed last November by London-based research firm Preqin showed that 23% said private debt exceeded their performance expectations over the preceding 12 months, higher than any other alternative asset class. Forty-five percent expected private debt to perform better over the following year, an increase of 800 basis points from November 2022. High interest rates were cited as the main reason for this optimism, as investors expected to see an increase in yields.

During periods of higher interest rates, investment in direct lending delivers returns of 11.5% compared to returns of 7.0% for high-yield bonds and 5.0% for leveraged loans, according to a research note from Morgan Stanley. At the same time, direct lending experienced lower losses during the height of the COVID pandemic, down 1.2% compared to a loss of 2.7% for high-yield bonds and 1.4% for leveraged loans.

Filings and performance from private credit funds already out in the market bear this out.

Cliffwater was a first mover in offering a private credit fund to the wealth channel with its flagship Cliffwater Corporate Lending Fund, a private credit interval fund that debuted in 2019 and currently manages $16.4 billion in assets. The fund focuses on core private credit opportunities. The company has since launched a second product, the Cliffwater Enhanced Lending Fund, which looks for higher risk and higher yield opportunities, including venture lending, royalties and second lien loans. Cliffwater is pulling in $800 million to $900 million a month from RIAs into its core fund and $100 million to $200 million in the enhanced fund, making it one of the top fundraisers in the limited liquidity alts space.

“From an asset allocation perspective, private debt has a lot of relative advantages to other asset classes,” said Cliffwater CEO Stephen Nesbitt. “Traditional bond yields are close to 4%. Private credit has an advantage of 5% to 6%. Against equities, the general consensus is 7% long term returns. If you can earn double digit returns on private credit and equities with all their volatility, are priced at 7%, it seems to be an easy trade to make. That’s what you’re seeing happen today. Cash flows going into private credit are primarily coming from equity allocations.”

Another product designed for the wealth channel is the Ares Strategic Income Fund, a non-traded business development company that invests primarily in senior, secured, floating-rate loans to U.S.-based companies, delivered a return of 13.13% on Class I shares for 2023. Speaking on an earnings call for the fourth quarter, Michael Arougheti, CEO and president of asset manager Ares Management Corp., said the company sees expanding opportunities in private credit as traditional lenders rework their balance sheets in the wake of last year’s troubles in the regional bank sector.

“Once we get past this first phase of balance sheet restructuring and repositioning, I think you’re going to have a lot of banks—regional, super-regional and GSIBs—just rethinking core businesses and balance sheet positioning. And we put ourselves out there as a proven partner for them as they go through that. So, I think it bodes well for continued deployment,” he said.

Blue Owl Credit Income Corp., another non-traded BDC with an investment profile similar to ASIF, delivered total net returns of 15.77% for 2023. The fund raised $1.2 billion in the fourth quarter, a 30% increase compared to the third quarter of 2023.

The direct lending business remains strong, noted Marc Lipschultz, co-chief executive officer with asset manager Blue Owl Capital during the company’s most recent earnings call. “We again saw booming trends in deployment in the fourth quarter, with a constructive environment so far in 2024.”

Funds Get Bigger

In early 2023, the private credit market totaled about $1.4 trillion, according to Bloomberg. By 2027, Morgan Stanley forecasts it could grow to $27 trillion.

In December 2023, there were 1,072 funds in the global market targeting private credit, with $456 billion in aggregate capital, according to Preqin. Last year saw the closing of 196 private debt funds, with $202.2 billion in total capital raised. 

More granularly, of the 199 closed-end funds monitored by XA Investments, the sorts of funds most likely to be used by advisors, 62 focus on credit with $53.2 billion in assets under management. 

“The funds out there now, whether they are interval funds, BDCs or tender offer funds, make the administration much easier,” Cliffwater’s Nesbitt said. “What I’ve learned is you can have a good product, but if administratively challenged, forget it. But if it’s a good product and investors can get in and out, it’s a home run. We’ve done interval funds because we think it’s the most convenient, but others are offering tender funds or BDCs.”

This year will likely see the same amount of capital or more targeting private credit, with some unusually large private credit funds slated to close in the first half of 2024, according to Clarke. For example, Ares Management’s Ares Capital Europe VI will likely become the largest direct lending fund ever, with $21.9 billion in capital. Larger funds typically have higher minimums, meaning they are generally only open to qualified purchasers or accessed via feeder funds.

“Private equity has raised as much as $30 billion. You’ve never seen these types of sizes from direct lending funds,” Clarke said.

After the Great Financial Crisis, the banking sector never returned to the same level of lending it did before, creating a supply gap that became an opportunity for private lenders, noted Mercer’s Gregg Sommer. That gap only got larger last year, after troubles among regional banks spooked the whole industry.

“There is less lending going on. It only increases the opportunities for private credit,” he said. “So, I think there are a lot of attractive reasons to think that trend and those conversations we are having with clients will continue and that allocations to that asset class will continue to accelerate.”

Last fall, global private markets investor Pantheon Group registered an evergreen private credit fund that will focus on investing in debt through the secondaries market. When AMG Pantheon Credit Solutions Fund (PSECC) launches this spring, it will become the second investment vehicle spun by the firm’s U.S. private wealth division. The fund will focus on buying credit positions in performing floating-rate loans from mainly institutional clients in the secondaries market, according to Michael Hutten, partner with Pantheon and head of its private wealth division. Investing in the secondaries market will allow the company to evaluate the health of the loans with greater certainty, take advantage of shorter loan terms and buy at discounts that currently range between 10% and 12% for senior loans, Hutten noted. Buying at a discount will also protect investors if the market starts to see greater loan defaults, he added.

Today, whenever he attends an industry event, the majority of the speakers tend to be private credit managers, Hutten said. Individual investors and RIAs appreciate that the asset class delivers a healthy income, yields that are currently comparable to long-term public equity total returns and lower volatility than the public markets. “There’s just a tremendous amount of demand for private credit,” Hutten noted. “And then specifically for our fund, we are finding it’s very complimentary to what other managers are doing and finding a lot of demand for what we are bringing out.”

Pantheon plans to target income on senior debt for the fund that will be comparable to what investors see in the direct lending market, with capital appreciation ranging from 200 to 300 basis points. Those estimates are based on the firm’s previous experience in the private credit secondaries market, where it has been investing since 2018.

What if Interest Rates Go Lower?

With investors excited about the opportunity to achieve outsized yields from higher interest rates, what will happen if the Fed begins cutting rates, as it had indicated it might, later in the year?

In that case, the private credit funds will make less money but still do well, according to Clarke. Lower interest rates will likely stimulate more leveraged buyout activity, driving up demand for credit and lending volumes.

One of the biggest risks for investors in private credit today are the loans that were made at the peak of the market in 2021 and 2022, Clarke noted. In 2008, when there was a major uptick in defaults, floating-rate loans lost 30% of their value, he said. Since then, lenders have become more disciplined. But it’s still possible there will be some losses on loans made right after the pandemic when interest rates were near historic lows.

Hutten cautioned advisors making decisions about allocating to private credit funds to check if the managers they are working with have experience investing in private credit through multiple cycles. The past five or six years have presented a relatively benign environment for the asset class, with few defaults, he noted. That may not remain the case forever.

“I feel like because it’s become such a popular area to invest in sometimes the allocators forget that these are loans that are being made to private companies typically, and there is risk associated with making these loans,” he said.

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