Private credit’s returns attract investors and asset managers alike
Private credit is having its moment with investors and asset managers rushing to benefit from increased returns in an era of higher interest rates.
Private debt funds returned approximately 2.7 per cent to investors in the second quarter, according to the State Street Private Equity Index, higher than the 2.37 per cent delivered by buyout funds over the same period.
Much of private credit lending is done through floating rate loans, which benefit from rising interest rates.
Cambridge Associates, for example, expects direct lending and European opportunistic private credit funds to outperform their longer-term averages due to high asset yields and the pull back of traditional lenders from the market.
According to Frank Fama, co-head of the Global Credit Investment Group, direct lending strategies can deliver returns above the long term average of six to seven per cent for unlevered funds and eight to 10 per cent including fund level leverage.
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“Direct lending funds provide first-lien senior-secured loans to middle-market companies. These loans are typically floating rate and had a yield of around seven per cent when rates were low. Currently, with three-month secured overnight financing rate roughly 550 bps and credit spreads around 600 bps, investors are enjoying low double-digit asset yields. Direct lending funds will distribute that income quarterly,” he wrote in a note.
He added: “Loans structured in the current environment are more favorable to lenders than in the recent past. In a higher-rate environment, debt capacity of borrowers is lower, meaning leverage levels have come down and sponsors are contributing more equity to transactions. Financial covenants are being set tighter, helping to protect downside if the borrower underperforms.”
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But Andrew Watt, head of financial services, infrastructure and alternative asset ratings for the Americas at S&P Global Ratings, the pace of growth in the private credit market will slow as markets navigate the uncertainty around interest rates.
For Paul Watters, head of European credit research, the European market in particular will broaden and deepen as it deals with “a macro-credit environment that will require a recalibration of business and financial strategies for many midmarket companies”.
“Innovations will provide greater access to the small and midsize entities (SME) asset class for retail investors and more credit-conscious institutional investors in Europe,” said Watters. “Fund managers in the EU are establishing European Long Term Investment Fund (ELTIF) 2.0 vehicles that can include illiquid middle-market lending and subordinated debt, and be marketed to retail investors once the new regulations take effect on 10 January. These alternative funds can provide more liquid capital instruments for investors, subject to sufficient notice.”
In addition, the S&P team expects increasing cooperation between the largest private debt players and traditional banks with investment funds.
Read more: Asset managers respond to more demand for private debt liquidity
