Though no longer a new theme, non-bank lending requires a refresher. Everyone is by now aware of the limitations of bank finance and therefore the provision of alternative capital. The reality of this shift in credit to the private sector is that investors will wear the losses that banks used to do, but with a very different attitude towards managing that risk.
Domestic funds aimed at private wealth have also came to the fore in recent years and investors are now confronted with a sector that potentially has an excess of funds looking for the magical low-risk return above traditional fixed income.
Notwithstanding these provisos, the portfolio role of private credit is widely acknowledged, if built on a robust assessment of the investment fund.
There is a case to regroup and consider a set of questions to initiate a review.
- Firstly, why does the industry or sector need private capital and at what cost? This may appear as a simple issue, yet spells out the risk that others cannot or will not take.
- Secondly, what is there about the assets supported by the lending that is attractive? If one does not think that the business or asset backing has merit, it makes no sense to lend to these parties.
- How competitive is this sector, and is there an informational advantage that a fund manager can gain? The lender has a clear interest to look for the lowest, most flexible rate and low-covenant deal. Often the argument boils down to relationships. That’s great when they do make sense; but potentially terrible if they are about compromise and failure in appropriate arms-length judgement.
- Finally, does the illiquidity warrant the risk? The longer the time frame, the greater the possible change in circumstances. Term premia is a well-known concept, but the degree of uplift is likely to be underestimated in private lending and credit.
There is a distinction between private credit, as a deal directly between the lender and the business, and loan markets which have a bank as an intermediary. The fixed versus floating rate nature of the structures is another criterion.
Yet for many investors these are the same; the notional return is well above traditional fixed income.
Domestically, property of all stripes remains a high weight in many fund structures. The go-to measure is the loan-to-value ratio, though it would be over-simplistic to rely on this alone. In SMEs, the relatively small scale of business is another leap into the specific conditions that affect each entity. Equipment and leasing finance is typically an ongoing source of funding, while growth or transactional credit has a different risk.
Many investors are frightened by any reference to CDOs or CLOs given the financial crisis. The structure was not at fault, it was the extent of mortgage sub-prime and the ratings that implied low risk. Today these same collateralised structures continue to play a large role in US credit markets but in practice, senior, subordinated, mezzanine and distressed debt represent the bulk of activity.
Outside of the inevitable views on the repercussion of COVID, the global debates in private credit are concentrated on the interaction between private equity and credit and the growth in ‘covenant-lite’ lending. There is a natural resistance for credit extension to private equity within the same organisational structure even with allowing for independent teams. Reduced covenants are increasingly widespread in private credit, as competition of deals increases and the time frame to complete transactions narrows. One only needs to see how much hot air is created about the definition of EBITDA to sense tension between various investment managers.
As with other asset segments, the key does lie with manager selection. This is made harder by the absence of a list of participants. Comparisons are far from easy. As more come to attention, the level of information improves and it is worth casting one’s net widely to hone-in on options that pass the test.