This ‘Higher-Yield’ Fixed Income Is Picking Up – But Defaults Have Doubled

However, private credit and private equity, are very closely intermingled, explains Michael Dimler, Senior vice-president, corporate ratings, private credit at Morningstar DBRS. A global firm will be involved in many areas, on one side investing, on the other, lending, like two sides of a same coin. “Private equity owns the companies to which private credit firms lend,” Dimler points out.

As Banks Retrench, Private Credit Advances

Private credit has little visibility, certainly less than its private equity flip side. So, it is a surprise to learn that the credit side, according to some evaluations, would already be larger than its equity one. It stands at US$ 1.6 trillion globally according to Prequin, reports Nick Smith, Managing director, private credit at the Alternative Credit Council.

That’s quite a growth rate for a market that stands in the shadow of private equity which, according to two studies, is half the size. Research and Markets values global private equity at US$645 billion in 2022, growing at 13.4% through 2028, while Allied Market Research sets it at US$445 billion in 2022, reaching US$1.1 trillion by 2032 at a compound growth rate of 9.7%. However, those evaluations would be largely off-the-mark if one refers to Prequin's present estimate of about US$6.0 billion for the private equity side, shooting up to US$8.5 T by 2028, again as reported by Nick Smith.

Banks remain the main providers of financing for firms, with a global share of 78% of loans. But they are retrenching and will continue to do so, asserts the report. “Banks have to prioritize and think carefully about the markets they want to be in, Smith comments. You can’t be all things to all people. That has left certain sectors with a lack of supply. It’s a complaint from SMEs: it’s more difficult to get lending from banks, and the banking model doesn’t suit them.”

Once a last resort option, private credit increasingly stands alongside other channels like banking or bond issuance. “It is a key option when you want to take on debt,” Smith says. Calling on private credit is more expensive than doing business with a bank, but it carries three major advantages, Dimler points out: “A private lender can have a much faster execution thanks to less regulatory oversight, there’s the ability to take on more risk per borrower, and loans can be more closely tailored to the business’ needs.”

In the Shadow of Shadow Banking

The name “private credit” may stir up memories of the infamous “shadow banking” sector that haunted the 2008 financial crisis, with firms like hedge funds, mortgage lenders, and investment banks that behaved like banks, but without the supervisory apparatus governing banks. Nick Smith denies any resemblance. “Our members are very well regulated by asset management regulations, with requirements of transparency and disclosure. The comparison with banks, which are highly levered institutions, is not necessarily helpful. Firms tend to be much less levered; 85% have a 1.5 leverage or lower.”

Dimler agrees that the sector is not overextended. Not yet. “For now, the ‘tent’ is big enough to take in all interested parties, he says. But over time, we believe that more  capital inflows could lead to relaxed underwriting standards; that’s just the way things tend to evolve. I don’t see this market as immune to the types of risks that have historically affected other asset classes.”

Shaky Lenders, Fragile Borrowers

The sector is not always serene, observes Justin Jacobsen, portfolio manager of the Alternative Absolute Return Fund at Penderfund Capital Management who closely monitors it for “shaky lenders”. The loans forwarded by private creditors “have floating rates with a big spread, often in the range of 5.3% to 12.3%. They involve a lot of expense for fragile businesses to bear.”

Returns generated by private credit firms have been as remarkable as the loans are expensive. A comparison on Wealthsimple’s website, which offers a new vehicle to wealthy clients with $100,000 to invest, compares the 8.9% performance of private credit since 2007 as of April 4, 2024, to the 8.8% return of U.S. equity over the same period, and the returns since of 5.7% for U.S. high yield bonds, of 4.1% for U.S. corporate bonds and 2.9% for U.S. Treasuries.

However, Jacobsen is wary of investing in PC which has not yet lived through a full business cycle and, “we do have concerns about what we expect to be a default cycle in the relatively near term”. He points to two publicly traded players (commonly identified as BDCs, or “business development corporations): Oaktree Specialty Lending (OCSL) and FS KKR (FSK). In the present environment of sustained high interest rates, both are witnessing a sharp increase of default levels in their portfolios. In the case of Oaktree, they have more than doubled from 2.4% in the second quarter of 2023 to 5.9% in the third quarter; in the case of FS KKR, they have also nearly doubled from 4.8% to 8.9%.

For the time being, Jacobsen steers clear from private creditors. “They have never been holdings in the fund I manage,” he says, “but I think there likely will be a point in the cycle where the risk/reward will make sense for us.” That point is presently not close at hand.