As asset owners ramp up their exposure to private credit, they also need to be careful because if defaults climb or demand for loans decline, their portfolios could be negatively affected, industry insiders say.
"Manager selection will be key in making sure investors achieve good private credit outcomes, particularly given the fund horizon means locking up capital for five to seven years," said Nimisha Srivastava, Chicago-based global head of credit, Willis Towers Watson PLC. "We believe manager dispersion (difference in outcomes) is likely to be greater going forward given the growth in strategies."
Key attributes to consider are manager credit underwriting skills (an experienced and large enough team to properly analyze companies) and expertise in distress should company stress rise, she said. Investors should also ensure that the fund size corresponds to the opportunity set the manager is focused on (not being too aggressive with fund size to focus on attractive return on capital for investors), Ms. Srivastava added.
Driving investors into private credit is not only the search for yield in a low-interest-rate environment but also returns in the form of a liquidity premium over bonds that exist right now, she said. "This is not always the case, but it is as wide as we have seen it."
Compared to October 2019, when the illiquidity risk premium for U.S. direct lending was under 50 basis points, which is below its fair value range and therefore unattractive relative to its holding period and public market comparisons, WTW's current illiquidity risk premium for private credit is closer to 200 basis points, above the fair value range.
There is a significant need for capital by middle-market companies undergoing economic stress as a result of the pandemic, she said.
The pandemic accelerated "the ongoing secular rotation of debt capital to private capital providers away from banks," said Christopher G. Wright, managing director and head of private markets at credit manager Crescent Capital Group LP, which has about $29 billion in assets under management.
"The growth in invested private credit dollars was also driven by low redemptions as well as increased borrowing (by companies) to meet liquidity needs, add-on acquisitions, and/or to fund growth initiatives," he said.
What's more, prior to the beginning of the pandemic, "there had been a strong M&A market that had pushed leverage toward record levels," resulting in a need for private credit, said Christopher Taylor, head of New York Life Investments Alternatives and CEO of New York Life's $11.8 billion credit manager subsidiary, Madison Capital Funding LLC.
Willis Towers Watson estimates the total size of all private debt including real assets, specialty finance, distress debt and longer lockup credit at about $1 trillion, which is comparable to the U.S. high-yield bond market that is about $1.2 trillion, Ms. Srivastava said.
As more money is flooding into private credit, funds are getting bigger, she said.
Private credit funds worldwide have been raising at least $100 billion per year since 2015, according to Preqin data. In 2020, 200 private credit funds raised $117.7 billion, 11% less than the record amount of capital raised in 2019, $132.1 billion by 223 private credit funds.
"Big funds are tending to get bigger. We're seeing fund sizes increase and what that means for returns and how selective they (the managers) will be are questions we ask," Ms. Srivastava said.
If a manager raises a larger fund, such as $3.5 billion instead of the $3 billion the manager raised for its last fund, the question is whether that credit manager will achieve the same risk-return profile, she said.
"The bigger you get, the less selective you can be," she said.
U.S. institutional investor interest in the asset class is undeterred, while being cognizant of the risks.
CalPERS does not have a private credit allocation but officials are interested in investing more in the asset class along with other alternative investments. CalPERS is embarking on a new asset-liability review in 2021 that is expected to be completed in November. Pension fund officials are aiming to invest more capital into private credit along with other alternative investment asset classes to boost returns, Dan Bienvenue, interim CIO of the $426.2 billion California Public Employees' Retirement System, Sacramento, said at a stakeholders meeting on Jan. 21.
