Private credit is having an extended moment center stage.

Institutional interest in private credit remains high because it provides opportunity for diversification and solid return potential, and when invested in high-quality funds with robust deal terms, it can offer defense from the fluctuations of the economy. High interest rates in recent years have also been a tailwind for many private credit strategies, now estimated at nearly $1.7 trillion in total assets under management, according to Preqin.

“You’re potentially getting low double-digit asset yields, and that continues to attract a lot of attention,” said Frank Fama, co-head of the global credit investment group at Cambridge Associates.

Private Credit Webinar

Our panel of experts will share their macro perspective and its impact on current and potential opportunities across private credit. They will dig into the nuances of specific segments and their underlying market drivers. And in a shifting rate and credit cycle that has resulted in a wider dispersion of returns by managers, they double-down on the type of manager experience and expertise needed in private credit in order to deliver the risk-adjusted returns that investors seek.

Featuring

Shelley Morrison

Head of Fund Finance and ABS

abrdn

Isaiah Toback

Deputy Co-Chief Investment Officer

Castlelake

Alex Chi

Co-Head of Americas Direct Lending

Goldman Sachs Asset Management

Frank Fama

Co-Head of Global Credit Investment Group

Cambridge Associates

MODERATED BY:

Gauri Goyal

Senior Director, Content & Programming

Pensions & Investments

Wednesday, September 11, 2024

2:00 p.m. ET

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Corporate borrowers under stress from high interest rates have been turning to the private credit market as an alternative. “We’ve seen a lot of activity around capital solutions from companies that have gotten over their skis, in terms of their interest burden, and need some sort of relief,” Fama said. “Managers in the credit opportunities space have come in to provide a different type of facility that may relieve some of that interest burden. That’s increased the activity in the asset class significantly.”

Another factor driving the supply side is the relative lack of bank financing. Banks began to pull back from lending when regulators tightened their capital requirements, said Greg Olafson, global head of private credit at Goldman Sachs Asset Management. “There’s been a secular shift from lending in the banking system to the nonbanking system, where savers are acting as lenders, and we think that’s a trend that will stay intact,” he said. “Ultimately, it’s a better business model, and there’s better asset-liability matching.”

On the demand side, the macro environment that had for years favored traditional alternatives such as private equity and venture capital appears to be changing, said Evan Carruthers, managing partner, chief executive officer and chief investment officer of global asset-based investment firm Castlelake. Asset-based private credit seems to be an increasingly appealing alternative for allocators that need to put capital to work but don’t want to increase their growth and equity exposure in the current environment, he said. “It’s potentially a more defensive way that perhaps might be a good solution to a higher rate world with slower growth.”

“You can seek to capture excess yield through lending and I think that has piqued the interest of a lot of institutional investors,” he said.

Other sub-asset classes also continue to command high investor interest. That’s true particularly for fund finance — subscription lines of credit to private market funds of all types — because investors are attracted to its return predictability and certainty around capital calls, said Shelley Morrison, head of fund finance and asset-backed securities at abrdn.

“In a higher interest rate environment, investors don’t want to be holding their commitments in overnight liquidity that’s not earning very much,” she said. “They want to be thoughtful about where they are investing. What we’ve seen in this environment is that subscription lines are very helpful from an investor-relations perspective because when general partners use them, investors get to be more strategic with their management and their liquidity.”

Read: Private Investment Benchmarks

While demand from pension funds and insurance companies for private credit has remained strong, interest has expanded to all types of institutional investors, Morrison noted. It’s also the stability factor. “Beyond the strong risk-adjusted returns, this is an income asset; it’s about capital preservation,” she said.

“Pension funds historically have been the largest consumers of private credit, and they tend to have a specific allocation to the asset class,” Fama added. “Increasingly, we’re seeing endowments and foundations and private clients interested in the asset class and thinking about how to allocate to it.”

Positive market fundamentals underpin demand for direct lending across investor types and vehicles, said Olafson of Goldman Sachs. “All-in yields are attractive, and performance over time has been very good. And while spreads may have compressed somewhat in direct lending, absolute returns remain attractive in historical terms,” he said. “Interest has extended from the sub-investment-grade direct lending to both the lower-risk investment-grade asset-based finance and the higher-risk hybrid capital part of the market.”

Source: Cambridge Associates LLC. 
Notes: Portfolio shown for illustrative purposes and not representative of actual portfolios managed by Cambridge Associates LLC or its affiliates. Figures are intended to be directional.

In addition to the current favorable market environment, asset-based private credit strategies can address several portfolio objectives for institutional investors, including generating return, diversification and downside protection.

“There are several drivers that have renewed interest in asset-based private credit,” said Carruthers of Castlelake. “First and foremost, it’s a tool for a lot of institutional limited partners to potentially earn what I view as excess return per measure of risk, particularly when compared to the public liquid markets.” In addition, he believes that asset-based private credit has provided a more defensive path for investors who need to reallocate some of their alternative growth equity exposure.

Private credit strategies like specialty finance can also provide a more granular diversification when compared with both other credit strategies as well as asset classes that withstand economic cycles. “It’s a pool of assets, so it’s diversification away from single-name corporate risk,” Fama said. “Some of the assets — for example, in life sciences — may give you some diversification away from economic cycles. Others — music royalties, for example — may perform well across economic cycles.”

Similar to the different styles of equity investing — growth or value, for example — the sub-asset classes in private credit can deliver different portfolio objectives, such as capital appreciation or income. In addition, similar to other asset classes, private credit has different levels of risk — and corresponding return — that investors can leverage. But in private credit, those levels are deeper and more varied.

“As you move up and down the risk spectrum, there are different risk and expected return profiles,” said Olafson at Goldman Sachs Asset Management. “As you move up into the higher-risk segments, you should earn a higher return. There are many ways to construct a portfolio to satisfy your investment objectives.”

Sub-asset classes range from direct lending, asset-based finance, broadly syndicated loans and mezzanine debt to hybrid strategies that blend characteristics of equity and debt. Some of the newer products, designed for high-net-worth investors, have expanded both the product universe and the pool of capital to invest, he noted. “Across the board, interest in lending remains high,” Olafson said.

Read: Public and Private Credit: Capitalizing on Coexistence

At Cambridge Associates, Fama builds private credit strategies with several components that together are designed to help meet a client’s risk tolerance or portfolio objective.

“We think of direct lending, or senior debt, as a component, and then we’ll put that together with credit opportunities. What you’re getting there is a potential return from direct lending and a little bit of income. But if there should be a dislocation in the market, the credit opportunities are intended to benefit from that,” he explained. A third piece would be specialty finance, which gives you a different risk exposure than what you might have elsewhere in your portfolio, he noted.

“Think of this approach as a third, a third, a third — but then you can dial those allocations up or down, depending on the client’s objective,” Fama said. For example, the direct-lending component can be increased for a risk averse, income-seeking client, while the credit opportunities sleeve can be upped for a client more interested in maximizing returns. Also, investors can consider the different tranches of the lending market, depending on their risk appetite and return target.

“In the lower-middle market, there’s fewer players; so you tend to get better terms, better pricing,” Fama said. “In the core middle market, it gets very competitive. And then in the upper-middle market, you’re competing against the public markets; so that’s where you tend to see the tightest spreads and the weaker terms, but it may still be attractive relative to the public markets.” Acknowledging that there are overlapping gray areas between the segments, Fama defined the lower-middle market as companies with $10 million to $50 million in EBITDA; the core middle market as those with $35 million to $100 million in EBITDA; and the upper-middle market as companies with $75 million or more in EBITDA.

Seeking to generate excess return without loading up on risk is Castlelake’s focus, whose asset-based private credit strategies are designed to potentially deliver double-digit rates of return with risk control.

Asset-based private credit “fits a sweet spot between public, liquid fixed income and alpha-generating alternatives, whether that’s opportunistic credit, venture capital or large- and mid-cap buyout funds,” Carruthers said.

For investors, the strategy can pay yield in several ways, including coupon payments from loans and the final maturity of the loan. That’s become increasingly attractive as other sources of yield tighten. “It provides investors coupon delivery and liquidity, which many of our investors find quite attractive in a world where liquidity continues to be scarce and where many higher-yielding riskier asset classes, like venture and private equity, have not been delivering as much liquidity,” Carruthers said. Not only can investors pursue several types of vehicles, he noted, there’s also no shortage of sector opportunities to consider across asset-based finance.

Institutional limited partners can construct private credit strategies so that the quality profile of borrowers best matches their portfolio’s target risk. “Some orient more toward noncyclical, larger businesses with a cash flow orientation to them,” Olafson said. “We’re quite privileged to be able to lend to and access high-quality companies like traditional software, business services and certain kinds of healthcare, and not have to reach for businesses that have secular headwinds or cyclical dimensions.”

“We have a lot of experience assessing risks, structuring around those risks and pricing those risks,” Olafson said. “If we’re getting paid well and we think we can box the risk, then we’ll price that risk in those strategies. Our investors understand that we’re going to be navigating those types of opportunities.”

Source: Castlelake, L.P., A Primer on Asset-Based Private Credit, April 2024

As a manager specializing in asset-based private credit, Castlelake has been able to step in and provide financing to asset originators when liquidity from other sources tightens. “As banks retrench and access to markets like structured finance or asset-backed securities becomes a little bit more sporadic, our capital typically can step in to fill that void and add a tremendous amount of value to originators,” Carruthers said.

It’s also a way for the manager to find opportunities. “One of the ways we originate is to identify those liquidity voids, many of which are driven by pockets of the marketplace where banks are stepping away from asset classes that they had historically been aggressive in financing,” he said.

Castlelake’s approach to originating deals is to seek to control the pipeline. “Our origination process is unique in that we try to own and control as many of the origination channels across target asset classes as we possibly can,” Carruthers said. “One of the ways we strive to deliver value to our LPs is by giving them consistent flow of product at attractive risk-adjusted rates of return.”

The manager’s experience is another differentiator. “A lot of private credit firms were started post-GFC,” he said. In his view, investors are right to “be skeptical of general partners migrating into asset-based private credit that haven’t historically executed the strategy because it needs specialized expertise.” An asset-based private credit manager should also have knowledge of structured finance and ratings advisory skill sets, according to Carruthers. “Both those skill sets require a unique human resource base that you can’t snap your fingers and create.”

Today’s macro environment, with bank retrenchment and uncertainty around interest rates, presents no shortage of opportunities. Three attractive segments are consumer finance; small- and mid-sized business finance; and aviation finance and leasing. “We believe there’s a meaningful amount of opportunity to finance consumer credit, both in North America and Western Europe,” Carruthers said. Both regions have also seen significant bank retrenchment in small- and mid-sized business finance, allowing Castlelake to “effectively recapitalize the origination of that credit.” With the COVID pandemic hitting the aviation industry, where airlines retired aircraft aggressively only to see travel demand recover quickly afterward, “you have an under-supply of assets and credit constrained,” he said. “So we have been aggressively pursuing ways to extend capital to that sector because we love the fundamentals.”

Read: A Primer on Asset-Based Private Credit

Although fund finance — also referred to as subscription line credit facilities or capital call lines — is a fairly niche sub-asset class in private credit, it has drawn growing institutional interest for its diversification and stability. “When we speak to investors, there are three main reasons that they’re interested in subscription lines,” said Morrison at abrdn. “The first is credit risk diversification, the second is the stability of the asset class” and the third is strong risk-adjusted returns, she said. “Investors are looking for an asset class that is defensive, with low levels of volatility, and that performs well throughout the credit cycle.”

“Investors like subscription lines because they can deliver strong risk-adjusted returns — with an illiquidity premium over a similar-rated asset with similar tenor — in the public credit market,” she said. In addition, abrdn’s fund finance strategy offers diversification away from other private or public credit strategies, such as direct lending, real estate loans or investment-grade corporates, said Findlay Hyde, investment director, private credit, at the firm.

Abrdn leverages opportunities across the risk spectrum to deliver credit risk diversification and stability. “Within private credit, we focus on a range of investment-grade specialist strategies that include infrastructure debt and commercial real estate lending, fund finance and private placements,” Morrison said.

“We have multiple origination channels to ensure that we have access to the most attractive finance deals across the market at any given time,” she said. “We originate directly from sponsors, GPs and managers, but we also source a significant number of opportunities through our bank relationships.” Regarding the latter, “banks are keen to partner with institutional investors that have experience in this asset class. In some cases, we’ve sourced attractive seasoned assets from banks that are looking to derisk or to manage counterparty limits.”

When considering fund finance investments, abrdn evaluates each manager’s track record. “We like working with funds that show strong performance and, crucially, strong fundraising capability across a diversified and high credit quality LP base, with risks split across often hundreds of different investors in the fund,” Hyde said. “That’s the most important thing for us because that’s our collateral, the capital of those investors in the funds.”

Institutional investors evaluating subscription lines are often curious about where it should fit in their asset allocation. “Usually investors look at this as an alternative to the public credit market to help achieve enhanced returns without sacrificing credit quality,” Morrison said. “It’s an alternative to other forms of private credit, such as direct lending.” Demand for these more niche strategies like fund finance is likely to remain robust, she said, as “what we’re seeing is a desire for investors to insulate their portfolios from uncertainty, volatility and stress.”

With the burgeoning capital flows into private credit in recent years, a question that’s on the minds of more institutional investors today is whether asset managers have the ability to access or directly originate deals that will be appropriate to their investment objectives. The answer: There’s no one-size-fits-all.

Goldman Sachs Asset Management pursues a direct origination model which, Olafson emphasized, is critical to success. “The directly originated model is take-and-hold,” he said. “You are better able to assess risk because you get that direct diligence access as the lender. That really is a critical piece.” While identifying attractive opportunities in private credit is not difficult, accessing them can be. “Everybody can see that it provides good deals, but you have to get behind the velvet rope, so to speak. And we have very deep, very long-standing and very comprehensive relationships.”

Origination capability is a key factor that Fama at Cambridge Associates considers when assessing managers for clients. “In opportunistic strategies, we’re looking for people that can originate unique investments, because they can structure deals the way that they want and earn a better return,” he said. “They need to be nimble and originate interesting opportunities. That becomes more important in this sector.”

For some private credit sub-asset classes, due diligence includes not only the primary manager, but also secondary managers — each of whom may have a different investment style. “For direct lending, we like a large manager that has been around a long time and has experience with credit cycles. We like teams both with the experience and the resources,” he said, versus the more opportunistic strategies, where direct access to unique investments is more important.

Investors are keen to work with private credit managers who have strong investor-relations expertise and a high level of transparency. “The client and the manager should have a close, enduring and transparent relationship,” said Olafson. “It is imperative upon the manager, who is the fiduciary, to communicate, to be transparent and to share performance and market views with the capital providers.” In fact, as the private markets have grown, managers have had improve their efficiencies in delivering critical information to limited partners. “I would stress that capital providers should expect transparency, engagement and an understanding of their risk exposures” from their manager,” he said, which needs appropriate technology and systems to do so efficiently.

And since each investor has a different risk perspective and tolerance, customization is key. “The metrics that you will need to focus on — apart from just performance, beating the benchmark and risk-adjusted returns — differs by client,” said Olafson. “It’s all those things, but ultimately, you’re talking about the specifics of that client’s needs and how you can help.”

Read: Fund financing: Credit where it's due

As investors monitor economic risks to private credit as an asset class, given that inflation remains elevated in some industries with the potential for slowing growth, they should keep an eye on default rates.

“We’re seeing pockets of stress in different sectors, particularly what have been thought of as more stable sectors like healthcare, because of wage inflation and other issues where they can’t increase their revenue, and software, which may not have met expected growth targets,” Fama said. While these sectors are not showing defaults, there is some under-performance that requires attention. Overall default rates for private credit are in the 2% range, he said, which is typical in a relatively calm economic environment.

In fund finance as well, default rates are historically low, which is partly due to the nature of the investment. “In subscription-line lending, you’re taking credit risk against committed LP capital within a vehicle. You’re not taking credit risk against assets,” said abrdn’s Morrison. “That’s one of the reasons that we aren’t seeing an uptick in stress or a pickup in default rates.” But she expects to see greater dispersion in manager performance, particularly as the macroeconomic environment changes. “It will highlight managers that have been very disciplined with their underwriting and structuring, and that have had a collaborative relationship with the borrowers,” she said.

Source: Goldman Sachs Asset Management. As of September 2023. For illustrative purposes only.

Even if the Fed’s next move to lower interest rates will take some time to flow through the economy, it would ease the pressure on borrowers — further driving investor interest in private credit as companies seek to refinance.

“Without question, when rates come down, transaction volumes will pick up,” Olafson said. As investors anticipate a new economic and credit cycle, it can help power the private credit markets. Investors will “look through to lower all-in-all base rates, and they’ll be willing to transact, which ultimately is what needs to happen to allow buyers and sellers to clear.”

“If the Fed is lowering rates to relieve the expensive cost to borrow as opposed to addressing weakness in the economy, which might cause a more rapid decline, then I think there may be a scenario with continued stability and attractive yields” in private credit, Fama he said. “Rates would be somewhat lower than they are now but still would be elevated relative to where they were for the last decade.”

Carruthers said that while a low-rate environment is not “great” for private credit, “I don’t think normalized rates are going to go back to what we experienced in 2016, 2017, 2018. We believe that what is unfolding is a slow transition to a more normalized rate environment.”

The industry’s shift away from a product orientation to a solutions mindset has led to greater collaboration between manager and investor. That’s important as the economic backdrop — and institutional investors’ goals — change more quickly than ever. “The dialogue has shifted a great deal,” Olafson said. “It’s not about, ‘We have this fund.’ It’s more, ‘We are partners. What are your objectives? What are your big challenges?’”

Whatever the future holds, businesses will continue to need to finance growth, and they will turn to private credit for the most attractive financing they can access — with institutional allocators not far behind.