In an era where traditional stock and bond portfolios struggle to diversify and achieve the targeted return on investment amidst persistently high inflation and interest rates, investors and fund managers are actively seeking alternative asset classes to fortify their portfolios. It is an interesting time where:
The market is unpredictable and volatile. This has impacted traditional lenders where loan issuance fell, which has created a gap for private credit investors to fill. The reluctance of businesses to settle for lower valuations has also created opportunities, with private credit emerging as one of the limited options for capital.
High interest rates remain sticky. Private credit offers a yield advantage over equivalent-rated corporate bonds, allowing investors to benefit from rising rates.
The quest for stable income and finding alpha from alternative sources in this challenging economic landscape has propelled exploration into private markets, with significant exposure and interest to private credit.
Investments in private markets have surged in Singapore, with private capital delivering a robust IRR of 15.1%, outperforming major indices. Private credit funds have exhibited resilience, returning 4.2% in the first nine months of 2022, while other sectors faced significant losses. Private credit AUM has also tripled since 2011, projected to reach $2.3 trillion by 2027. The increasing number of funds and raised capital underscore investors’ preference and overweight allocation. As such, private credit is rapidly gaining prominence due to its dual appeal as an asset class delivering stable risk-adjusted returns and a pivotal source of corporate funding. Investors are drawn to the prospect of alpha, offering additional yield, diversification, and co-investment opportunities. Concurrently, for borrowers, private credit emerges as a means to diversify funding sources amid challenges in securing funds from traditional lenders. The ease of access to capital in underserved segments, with flexible solutions and financing certainty has attracted a large base of borrower.
From a corporate structure perspective, private credit is positioned strategically higher in the capital structure compared to equity, emerges as a robust shield for investors seeking downside protection. This advantageous positioning allows fund managers to implement monitoring protocols, promptly identifying early indicators of financial distress within underlying assets. In contrast to the public markets, fund managers can actively engage with portfolio companies, renegotiating lending agreements, facilitating equity recapitalization, and providing guidance—a level of involvement often unattainable in public markets. This heightened degree of active oversight contributes to the resilience of private credit alternatives, enabling managers to analyze historical reporting and trends.
Beyond the capital structure, private credit emerges as a diversification focus, showcasing a low correlation with traditional stocks and public bonds. This inherent diversification sees private credit as an attractive addition to conventional portfolios, such as the classic 60/40 portfolio, especially during periods of elevated inflation where stock-bond correlation is stronger, incorporating private alternatives with low correlation to traditional public markets would be a resilient strategy.
While private credit presents a combination of merits, navigating this financial landscape is not without its risks. In accordance with the findings and insights from a comprehensive white paper by Moonfare, the four key private credit risks and mitigations are listed below:
Increased likelihood of corporate debt defaults during economic downturn | Private credit fund managers can leverage this scenario to negotiate more robust loan terms and incorporate stronger covenants, a flexibility not readily available in public credit. The current surge in demand for private solutions, amid limited access to public credit markets, underlines the significance of these tailored approaches.
Moreover, the close relationships private credit managers maintain with portfolio companies enable early detection of financial risks, offering the opportunity for timely risk mitigation through loan restructuring at various stages. |
Interest rates will revert downwards | Mitigants include interest rate floors, hedging and debt refinancing. Notably, these funds typically hold debt instruments for a relatively short period, around two to three years, reducing sensitivity to price fluctuations. Crucially, the majority of the spread for private credit managers is driven by company performance rather than interest rates, irrespective of the interest rate environment. |
Private credit remains an illiquid asset class | Contractual debt repayments partially alleviate liquidity constraints. Additionally, the shorter fund life in comparison to private equity and the growing secondary market provide potential avenues for investors to offload investments prematurely. Private debt secondaries are on the rise as the market remains undercapitalized. |
Differing parameters to Private Equity | Success hinges on origination capacity, available resources, industry expertise, and the ability to source through extensive networks. These key elements not only contribute value but also serve as differentiators between top-tier fund managers and their below-average counterparts. |
As we delve into the dynamics of private credit, uncovering its resilience, diversification potential, and capacity for superior returns, we invite you to explore a unique investment opportunity aligned with these principles.
Sources: MAS, Bloomberg, Preqin, Moonfare, Abrdn, Blackstone, Lombard Odier