Private Credit – More Context & Updates

Private Credit – More Context & Updates

One of my continuous motivations for writing each week about markets and investing is to provide the context where it is lacking. Media machines are built on buzzwords and emotion and money is one of those highly emotional topics where the extremes get the clicks. Credit is typically not an extreme topic and is mainly dull to most people, but it is getting more coverage now, given the growth of private credit. I don’t think the media will do a fair job of providing necessary context as this asset class pushes forward, so here are some comments and considerations.

Distribution drives Wall Street

Much of Wall Street is built on massive distribution modes. Blackstone’s BREIT ($60B) and Starwood’s SREIT ($10B) are massive real estate funds that accumulate their assets mainly through sales channels at the major banks. Merril, Morgan Stanley, JPMorgan, UBS, and Goldman earn roughly 3% commissions plus trailing fees to place client funds into these REITs. If the typical wealth management fee is 1% per year, wealth advisors at these major institutions make multiples more income by placing clients into these funds. Consider the famous phrase, “show me the incentives, and I’ll show you the outcome.”

The same thing happens in private credit funds. There was an article in Bloomberg last week about how HPS, one of the largest private credit funds, is now limiting inflows to cope with demand. Next time you are pitched a private credit fund or any private fund, check the share class and the placement fees. Forward the details to me, and I’ll share my insights.

Context on Private Credit

The problem with the term “private credit” is that it encompasses all private market loans into one wrapper regardless of quality or nature. There is nothing fundamentally unique or different about private credit. Credit simply refers to borrowing or lending money. The “private” in private credit refers to using investor capital to lend money, meaning investors can invest in the loans.

The private credit industry emerged as a distinct asset class after 2008-era regulations put heavy restrictions on the types of loans that banks could make. The lending teams forced out of the banks ended up regrouping with investors who provided the capital to continue making loans to sectors that suddenly did not have any lenders.

In 2010, the total private credit market was around $300 billion, which is very small in the context of lending. The total residential mortgage market in the US today is about $16 trillion for context. Private credit as an asset class has grown to roughly $1.7 trillion. 685 new private credit funds were launched last year.

Yields and Liquidity

Private credit generally has much higher yields than public credit. In public credit, treasuries yield 5.5%, investment-grade corporates also yield 5.5%, and high-yield (junk) yields about 7.5%. Some high-yield public credit can be higher, but not by much. Interestingly, some higher-quality publicly traded private credit portfolios yield around 10-11%. That really shouldn’t be the case, but it is for now.

Private credit yields are closer to 9% to 14%, but the capital is locked up in a private vehicle for a minimum period. The lockup is there for a good reason. The loan duration, whether two or seven years, needs to match the investor timelines; otherwise, there will be significant liquidity issues at some point. Most longer-term oriented investors do not always need their capital available, so this liquidity constraint should be acceptable.

Focus on Quality

The names of the private credit funds tell you almost nothing about what’s in them. The credit quality, the seniority of the loans, the covenants that protect the investors, term or duration, fund leverage, fees, industry concentration, size of the loans, and so on will heavily influence the risk and the return.

Indexing private credit or any debt investment is not advisable. When you buy an equity index, you own the largest companies by market cap. That loosely translates to owning a continuously refreshing list of the most successful companies. That has worked well in theory and practice as long as a general rising economic tide supports overall prosperity. When you try to index debt, you end up owning the largest borrowers, and that fundamentally just doesn’t make sense. Debt indexification doesn’t translate to owning the most successful borrowers.

Private credit investors should focus on quality: the fund structure, the team’s experience, the protective covenants, the type of borrowers, the leverage, the diversification, the deal history, and so on. Also, note the industry focus as each niche strategy has distinct characteristics, whether distressed, opportunistic, venture, senior, subordinated or a particular industry focus. Quality will decrease with increased capital chasing more loans while the asset class grows. That’s already happening, and it will continue. Like anything else, the details matter. If there is interest, we may go into more specific details on each sector and strategy in a future article.