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Demand for private credit is growing among investors in 2022, but what is driving this trend?
Private credit is a hot topic as institutional investors look to place increasing amounts of capital into this rapidly growing asset class.
As the recent Alternative Investment Management Association (AIMA) Private Credit Investor Forum in Miami showed, there are huge opportunities in private credit. It is predicted to be the fastest growing alternative asset class over the next four to five years. A recent report by Preqin suggested that as interest rates rise and government support is wound down, private debt will fill that gap.
Its appeal comes from its potential for higher yields and role in bridging the gap between liquid hedge funds and illiquid private equity funds. Investors are moving away from traditional fixed income portfolios to seek the greater yields promised by private credit .
After the financial crisis, banks are less willing to lend in the private markets. The private credit boom covers a spectrum of lending, from opportunistic and distressed debt, alternative lending structures, private credit funds and business development companies (BDCs). BDCs are closed-end US investment companies which help small and medium-sized enterprises and distressed companies to develop and grow.
While some have suggested that yields may decrease as the market matures, there are no signs of that yet.
Overall, Covid-19 did not lead to a prolonged erosion of market value and equities have bounced back. This led institutional investors to take a more sanguine approach to risk and liquidity, benefiting the private credit market.
With interest rates low and traditional fixed income portfolios struggling to produce returns, private credit is attracting new capital. It is now seen as a legitimate asset class and I believe 2022 will see renewed institutional interest and continued growth.
Although yields look very favourable in the private credit market, this asset class is complex and requires managers with a firm handle on portfolios. The key to managing private credit effectively is the ability to monitor risk and liquidity.
However, it is document intensive and more operationally heavy even than syndicated loans. To manage it successfully you need people with the expertise and understanding to assist not just with the operational outcome, but also the legal consequences of how data is recorded and analysed.
In addition, environmental social and governance (ESG) issues are bringing the need to build stronger relationships with borrowers. Managers must engage more closely with the target company. It is important to understand what drives the borrowing company from an ESG perspective and to be able to provide the correct data as evidence.
As an asset class matures, standardisation becomes key as you attract greater capital flows and more investors. Industry bodies like AIMA are likely to come together to assess the best way to interpret data, perform due diligence and assess ESG standards.
Nevertheless, it could prove hard to standardise the market because private credit facilities come in many different forms and types of loan.
Standardisation might develop in business development companies. These entities are fully registered with the Securities and Exchange Commission (SEC) and, as such, provide a lot of transparency.
One question is how will private credit perform as both inflation and interest rates go up?
The consensus is that there is enough evidence from privately negotiated transactions to model outcomes and make future assumptions. These portfolios are expected to be robust in producing returns.
Indeed, so buoyant is this asset class that some observers suggest private credit will eventually replace traditional lending. Statistics back this up. For example, in 2008 there were an estimated 14,000 banks in the US. That has dropped to about 8,000 today.
With inflation on the rise, and equities affected by rising interest rates, private credit seems a sound diversification strategy. Built with excess cash flows, performance may be less severely affected if US interest rates rise.
Private credit managers will have to ensure that they continue to have a low cost of capital. The banks still in business are competitive, so managers must remain competitive to access deals, particularly in the larger cap environment.
New and exciting developments are on the horizon, powered by fintech, which is driving innovation in the credit market. New technologies are being developed around existing lending platforms, enabling embedded financing, financial inclusion and decentralised finance.
Private debt strategies and portfolios can require highly sophisticated models, so managers increasingly need support in areas such as reporting, customisation, IT and due diligence. Our tech-enabled, client-centric suite at Intertrust Group can provide the services to help your portfolio data management and outsourcing solutions.