Made to measure: Special report on investment-grade private credit

Investment-grade private credit is the golden child of the alternatives family. But a new wave of investors are set to shape the future of this lucrative market. Kathryn Gaw reports…

Investment-grade private credit is customisable, flexible and growing ever-more popular with investors. Over the past two years, the market has exploded, with some fund managers estimating that investment-grade issuances now make up as much as 90 per cent of the private credit market. As a result, GPs are now structuring deals with their investment grade in mind.

But with competition for deals intensifying, fund managers have had to become more innovative in order to carve out a share of this lucrative market. This has led to more niche issuances which are stacked with protective covenants and bespoke solutions created with specific investors in mind.

This is a far cry from just a few years ago, when investment-grade private credit was an $80bn (£61.42bn) market which catered almost exclusively to life insurers. According to calculations by Voya Investment Management, the investment-grade private credit market is now worth $1tn with issuances of between $100bn and $110bn per year. The average deal value is around $300m, while yields are typically between 80 and 110 basis points above the equivalent public market returns.

“The landscape for investment-grade private credit is bigger and broader than ever,” says Andrew Kleeman, senior managing director, head of corporate private placements at SLC Management.

“People are just now starting to understand it is broader than just the life insurance application. It’s going to continue to be the secret sauce for insurance companies, but I think we’ll start to see more and more take-up on the pension side.

Read more: LGIM: Private credit ‘here to stay’ despite risks in sub-IG market

“The asset class is getting more and more attention. The issuers that are coming to this market want to be investment grade.”

Investment grades are assigned by independent ratings agencies such as Moody’s and S&P, who rank private credit instruments based on the quality of the underlying assets, the expertise of the investment team and the likelihood of default.

Jessica Gladstone, managing director in Moody’s’ ratings process and oversight group, confirms that private credit fund managers have been intentionally structuring new products in a way that is intended to secure a higher investment grade in order to attract this new wave of investors.

“Many firms that used to be much more focused on the private equity side are pivoting to invest much more heavily in investment-grade companies through creative, structured investments that offer fairly stable, low-risk returns,” says Gladstone.

“These structures can be more bespoke to suit the specific needs of the company and can be raised without directly diluting shareholders or raising reported leverage.”

So who are the investors who are influencing these issuances?

In addition to the core contingent of life insurers, there has been a recent influx of property and casualty insurers, health insurers, and even pension funds seeking out investment-grade private credit. These institutions are not quite as conservative as life insurers, but market volatility and the high rate environment has led them to seek out fixed, long-term returns which offer some respite from the uncertainty of the equity markets. Investment-grade private credit fulfils all of these requirements, while also allowing for that bespoke approach that public markets simply cannot offer.

Read more: Take cover: Insurers and private credit

“The general increase in activity is driven both by private credit’s increasing desire to put stable insurance capital to work and also higher interest rates,” explains Gladstone.

“Less favourable market conditions for some industries may drive companies to look for alternatives to traditional equity and debt markets.”

As a more diverse pool of investors pour into the sector, they are reshaping the market according to their needs. Investment-grade private credit differs in one key way from investment-grade public bonds – these deals can come with a seemingly limitless number of covenants.

These covenants act as protections for both the investor and the issuer and they can range from the standard (for instance, a debt to EBITDA test) to something more specialised. Many investors are now requesting priority debt tests, which define the amount of secured debt that the company can have. And more recently, investors have been asking for covenants which are more akin to minority investor protections, which allow for easy exits under certain circumstances, and adherence to certain performance standards.

Every structure will always be bespoke to the issuer, and that is a core part of the value offered by these investments. As well as taking into consideration investor requests, the details of each issuance will depend on whether it is an infrastructure deal, a corporate deal, or a structured credit deal.

“On the traditional high-yield private credit, you’ll see covenant strength vary through the cycle,”  says Kleeman.

“When times are really good and everyone is competing, they’ll weaken the covenants and the definitions.”

Ongoing macro-economic concerns such as higher base rates and higher inflation have meant that fund managers and investors seem to be equally concerned with covenant protections at the moment. Both parties are motivated to create high quality issuances, starting with the underlying quality of the corporate or asset at the heart of the deal. Secured issuances have become more popular, and this has led to an uptick in asset-backed lending (ABL), infrastructure debt, credit tenant leases, and other loan structures where an underlying asset can be used as security.

Read more: “Death by a thousand paper cuts” as exceptions flood covenants

“We see investment-grade companies with ABLs from time to time, particularly if the companies have large amounts of easily saleable equipment,” says Gladstone.

An example of this would be United Rentals, an equipment rental business which uses its stock as security. It is currently rated Ba1 stable by Moody’s.

“The asset class as a whole has always been willing to do heavier underwriting, but there’s just been more and more opportunities and more issuers that see this as a potential solution than I think, ever before,” says Kleeman. “And that’s in both corporate infrastructure as well as structured credit opportunities.”

Investment-grade covenants are often designed to maintain pari passu treatment with other senior creditors, such as banks, who once dominated this space.

“The idea is that whatever the banks need, we need as well,” explains Kleeman. “That level of connection is a critical protection to make sure that other lenders aren’t getting ahead of us, and there are strong priority debt limits as far as how much can be secured ahead of us.”

In fact, private credit fund managers have been able to take advantage of a retrenchment by legacy banks, who have shown an unwillingness to lend in recent years. As market conditions start to stabilise, some analysts have predicted that banks and private credit firms may partner on more deals, which allow them to play to their respective strengths.

“The banks aren’t able to originate through the credit spectrum,” says Cynthia Sachs, chief executive of data company Versana.

“So a lot of loans that they could have originated a few years ago, maybe they can’t originate now for regulatory reasons. And that’s now falling to private credit. So now you have private credit getting involved in bigger loans and also gaining market share. And now the banks are starting to raise third party capital and create private credit businesses as well.”

Read more: Lenders introducing more flexibility to loan docs to beat competition

Private credit managers and their investors have an opportunity to shape the future of the investment-grade lending market, by demonstrating the value of flexibility and detailed underwriting. And they are already having an impact. The high degree of customisation has led to issuances which are so tightly managed that they are sometimes mistaken for fixed income investments.

During times of economic stress, it is easy to see why so many investors might be interested in this proposition. But as demand for these products continues to grow, they will face more scrutiny from managers and ratings agencies alike, and diligent underwriting will be the key to the sector’s long-term success. And it has been a long time coming.

“When I got into this industry 17 years ago, it was the sleepy corner of in the shop,” says Kleeman. “But now it is getting more attention.”

As the golden child of the alternative credit sector, investment-grade private credit has a reputation to maintain. As long as investors and fund managers stay on the same page and remain committed to mutually beneficial covenant protections and realistic yields, investment-grade private credit will continue to attract the attention that it deserves.