Why yield compression is creating new opportunities in private credit

Private credit yields are beginning to compress, but this opens up a range of new opportunities for private credit managers, industry experts have agreed.

At a roundtable event in October hosted by Alternative Credit Investor in partnership with fund administrator Aztec Group, a number of private credit chief operating officers (COOs) and chief financial officers (CFOs) met to discuss the challenges and opportunities facing the in-demand sector.

During a wide-ranging conversation, there were discussions around fund liquidity, domiciles, regulation, data transparency, and other market trends.

The panel looked at the ways in which the market has changed since the global financial crisis, reminiscing over the enormous growth of the private credit sector during a time when investors were desperate for yield. While it took a while for investors to become comfortable with the concept of private credit, by the end of 2022 corporate direct lending was practically everywhere. However, now this initial demand appears to be easing off somewhat.

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“The rise in rates really helped investors and potential LPs pile money into that asset class,” said one panellist. “Particularly levered direct lending because you could get 12 per cent net returns by just putting money into level direct lending, senior secured asset types.

“Now those yields are compressing slightly. But there’s a little bit more interest coming into credit ops and special situations which is creating new opportunities.”

During a conversation held under Chatham House rules, the industry experts swapped yield rates on their most recent fund vintages, with eight to 10 per cent IRRs appearing to be the norm. This, coupled with the higher rate environment, has led to slightly reduced demand for private credit.

However, one industry stakeholder noted that any discussion around yield has to be nuanced, because it depends on whether your fund overlaps a period of rising interest rates.

“Look at the deals that were done in a more similar environment to now,” they said. “The ones that were done in 2019 are obviously not looking as good now.”

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In the present climate, private credit fund managers also see opportunities in banks de-risking through synthetic risk transfers.

“We see them cleaning up their balance sheet, particularly at year end, which is an opportunity for us,” said one roundtable attendee.

“We need to be a bit careful that we’re not just entering back into those securitised types of bonds which every brokerage house is trying to sell. You want to stay differentiated. But I do think there is still opportunity to drive value through either acquiring portfolios from banks directly or synthetically.”

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The maturity of private credit has also made LPs more familiar with the intricacies of the sector, and they have become much more demanding, the panellists said. They are now asking for more detail on deals, and they are cognisant of the possibility of liquidity mismatches. This has led to a need for greater transparency and communication from GPs.

One industry stakeholder noted that while IRR is important, it is just one of the factors that investors now consider before investing in a fund. What’s more, the fund’s dynamics are likely to change during its life cycle, for example, there could be retradings, NAV lines issued, or continuations of the performing portfolio. Each of these changes will be subject to the same high level of investor scrutiny which can add up to higher fees.

“From day one, the limited partnership agreement stipulates the expectations to an investor and what a GP can do,” they said. “But down the line, you’re very much trading with your LP about what their tolerance level is and checking back in. It gets to a point where it becomes very expensive due to legal fees, administrative costs, etc, so that’s the economic trade off.”

Liquidity continues to be a hot topic in private credit. In order to meet new demands for liquidity from investors, GPs are doing much more cash management forecasting, but the roundtable attendees noted that these forecasts are only really valid for three to six months, when they have to be remodelled.

“I think there’s a disconnect between how managers manage the liquidity of portfolios and what investors probably would like them to be doing for their repayment,” said one participant.

“If I was on the investor side, I’d find it terribly cavalier that anything beyond six months is a sort of shoulder stroke.”

As a result, more and more private credit managers are becoming reliant on third party fund administrators such as Aztec Group. During a discussion about data transparency, one stakeholder shared that they would like to streamline their administrative workload, using an external provider to manage portfolio returns and metrics as a proprietary exercise and also report to LPs.

As LPs become more demanding, GPs are paying more attention to the third party providers who can help them grow their business sustainably. For some, AI represents a potential solution, but most of the roundtable attendees agreed that the technology is too immature.

“We’re more leaning on the external finessing of data before we ingest AI,” said one attendee.

Fund domiciles were also compared, and the attendees agreed that despite the popularity of Luxembourg as a fund domicile, they are still drawn to the “familiarity” of old favourites such as Jersey and Guernsey. One delegate suggested that Luxembourg was more appropriate for fund managers who also did hedging. For pure private credit vehicles, the consensus seemed to be that consistency is best, and in Jersey and Guernsey the onshoring of marketing passports has the benefit of creating a lower barrier to entry.

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Looking ahead, the huge demand for best-in-class private credit products, and the supremacy of the biggest GPs is making fundraising harder, the industry stakeholders said.

“Everyone is fundraising for longer,” said one. “Fundraising stays harder.”

“US-based LPs are still hugely over allocated to alternatives,” said another. “So until rates temper and they get distributions back on some of these PE deals – because capital markets just ground to a halt – until the big endowments and pension plans get their money back, we’re just not recycling.”

As another attendee noted, you have to get money out to put money back in, and with lower yields, more demanding LPs and new technologies flooding the sector, the need for fresh funds will be an ongoing issue for GPs. However, the roundtable demonstrated that fund managers are well aware of the challenges ahead and are already mapping out their solutions to these hypothetical problems.