Interest remains high in private credit

After a rough first half of the year in both public and private markets, asset owners have had to reassess portfolio construction.

Traditional fixed income has been battered by rising rates, inflation and duration risk. For private credit, these macro trends aren't having the same impact on returns.

Direct lending funds typically provide shorter-term, floating-rate loans that are secured. Another attribute: rising rates and inflation have boosted yields for private credit. And direct lenders are also typically higher in the capital stack, which can give them more power if a deal shows signs of trouble. They may be able to push for changes to loan agreements based on that position as well.

As a result, investment performance within private credit appears to be holding up — at least so far. Private funds reporting lags that of funds that trade in the public markets, however, according to data from San Francisco, California-based investment consultant Callan, performance for median top quartile funds yielded a levered return of 8-10% during the first quarter of this year.

Those yields are driving continued interest in private credit as an asset class. According to Pensions & Investments data, private credit funds raised $42.7 billion in the first half of 2022, up from $36.9 billion during the same period in 2021.

Chris Acito, New York-based founder, CEO and CIO at Gapstow Capital Partners, an advisory firm that consults on and builds credit portfolios for institutional investors, said it's likely that new asset flows will continue to come into private credit funds.

"Many institutions are still underallocated to private credit, relative to their target," he said. "With fixed income under pressure, if institutions have room to make new allocations to alternative credit where the yields are still strong, they're going to do it. There are also institutions that haven't fully developed their alternative credit programs and we are seeing more interest in building those programs out in response to current conditions."

Mr. Acito added that some of this trend has its roots in what happened with private credit during the pandemic. Many allocators paused new investments, hoping instead to find distressed discounts that didn't really materialize. Private credit fund performance during that time, however, did show resiliency and there was an uptick in demand for financing from these funds as companies and private equity fund managers sought liquidity that wasn't readily available in the traditional syndicated loan market. As a result, allocators now have a better sense of how these funds hold up when financial markets are under pressure, he said.

The majority of the activity in direct lending happens in the midmarket across sectors. Transaction activity has been relatively consistent across, but Ken Kencel, New York-based president and CEO of $39 billion Churchill Asset Management, the credit investing affiliate of Nuveen, said that countercyclical industries like health care and business services are well positioned to ride out current volatility.

"Broadly, companies and sponsors are in a strong financial position — balance sheets look good. We've adopted a more conservative profile and prefer transactions with durable businesses," he said. "Our overall deal flow remains strong and even with that conservative posture we're still looking at yields in the 8-9% range."

John Kline, New York-based managing director at investment firm New Mountain Capital, agrees. "There are structural factors to private credit that have significant benefits. Our basis has gone up, our origination fees are higher, we have less duration risk, and we aren't seeing the same volatility as the syndicated loan market," he said.

New Mountain, with assets under management of $37 billion, is also looking at countercyclical industries like health care, life sciences and business services but stresses there is a broad-based opportunity set.

"You have a lot of discretion in private credit in terms of the opportunities, it's not like a mutual fund where you have to build out an index and take the pain if one sector goes down. We're looking company by company and making sure we're comfortable with the business from a risk standpoint." The result, he said, is a portfolio with a quality tilt that isn't as sensitive to broad market moves.

Looking ahead, Churchill's Mr. Kencel noted that as more money comes into private credit, direct lenders are able to underwrite larger loans, which expands the opportunity set for allocators and fund managers.

"Private credit is continuing to take share from the syndicated loan market as it matures," he said. "There is greater certainty around whether a deal will close, transactions happen faster, and there is more flexibility around how liquidity solutions are provided. That has appeal for private equity sponsors and companies and it leads to better long-term performance for private credit funds."

Gapstow's Mr. Acito added that for investors that have already been in the private credit space, they're taking a closer look at other asset classes within private credit. "Investors want a diversified exposure, so they are looking at things like real estate debt, asset-backed lending, other forms of alternative credit that can come alongside a direct lending fund, fill out a portfolio and offer some measure of protection against inflation," he said.