The prognosis for private credit - lending through a downturn
By Jiri Krol, Alternative Credit Council
Published: 27 March 2020
As performance data begins to trickle in for Q1, we do not have results for most private credit funds. We anticipate the numbers will reflect the incredible shock to the economy caused by the COVID-19 pandemic. Yet, longer term, we believe the asset class will fare better than expected.
There is still a lack of understanding about private credit within even sophisticated parts of the asset management sector. Many see bilaterally negotiated private debt as risker than the high yield or the broadly syndicated loan market. However, even a cursory analysis of relevant data shows that private credit – mainly characterized by loans to mid-market companies – tends to perform in line with or even better than both the high yield bond market and the broadly syndicated loan market.
Many market observers use performance of the S&P Business Development Companies (BDC) index, which tracks the performance of the equity of BDCs – companies which invest in loans to small and medium-sized businesses – to forecast private credit returns. However, BDCs are not dissimilar to banks and their equity to bank equity. Would you ever compare the performance of high yield bonds with bank equity? Probably not, but this is what many do when relying on the BDC index as a proxy for private credit. This is even more relevant in today’s highly volatile market due to the COVID-19 pandemic.
Using the equity market prices of companies holding the loans is not representative of underlying loan performance on a historical basis and is something that is likely to be confirmed, yet again, once the current market stress subsides. In reality, these pricing swings will have much less impact on the end investors who hold the loans to maturity or through a restructuring. Indeed, research from the Alternative Credit Council shows that fixed term vehicles - which do not allow investors to redeem their shares until all loans have matured - are the most prevalent model of holding mid-market loans.
Data from the Cliffwater Direct Lending Index of unlevered mid-market loan returns sheds a much better light on how mid-market corporate loans perform, including throughout the financial crisis. Rather than the maximum drawdown of BDC equity prices of around 70% in 2008, the actual losses in the loan portfolios held by the very same BDCs were less than 8%. Incorporating this data into the analysis shows that the recovery rates achieved by private credit managers are much greater than what is typical in the broadly syndicated loan or high-yield bond markets. This suggests the risk-return profile for private credit, at least historically, is attractive and that it can play an important role in helping investors achieve the returns they need while also diversifying their portfolio.
The bilateral relationship between most private credit managers and their borrowers is a crucial differentiator, allowing the efficient resolution of issues should the borrower face more challenging circumstances such as the ones we face today. Indeed, we continue to hear of more and more examples of lenders supporting borrowers through these difficult times and protecting value for their investors, instead of simply pulling the plug or doing nothing when the going gets tough.
It is clear there will be challenges. Operationally, valuation will be a key area of focus for GPs, LPs and regulators alike. Furthermore, dealing with a borrower in default requires the commitment of more internal resources than monitoring a performing loan. And certain sectors, such as energy and hospitality, will be more stressed than others.
Private credit has tripled in size over the past ten years and is now the first choice of finance for SMEs and mid-sized businesses across all sectors of the economy. Once the current disruption subsides, private credit managers will be there to provide businesses with the capital they need and support the recovery.
The Alternative Credit Council (ACC) is a global body that represents asset management firms in the private credit and direct lending space. It currently represents 170 members that manage over $400bn of private credit assets.
The ACC is an affiliate of AIMA and is governed by its own board which ultimately reports to the AIMA Council.
ACC members provide an important source of funding to the economy. They provide finance to mid-market corporates, SMEs, commercial and residential real estate developments, infrastructure as well the trade and receivables business.
The ACC’s core objectives are to provide guidance on policy and regulatory matters, support wider advocacy and educational efforts and generate industry research with the view to strengthening the sector's sustainability and wider economic and financial benefits.
Alternative credit, private debt or direct lending funds have grown substantially in recent years and are becoming a key segment of the asset management industry. The ACC seeks to explain the value of private credit by highlighting the sector's wider economic and financial stability benefits.