Private credit offers growth potential and a low correlation to equities and fixed income.
This once-overlooked asset class is quickly becoming a mainstay of modern portfolios. As banks continue to tighten their lending standards and step back from loan issuances, the private credit market is growing, and investors are benefiting.
Consider that over the last decade, private credit “has generated higher yield than most other asset classes, including 3-6% over public high yield and broadly syndicated loans,” according to data from Goldman Sachs. Moreover, private credit has historically experienced lower loss ratios than those seen within high-yield fixed-income instruments.
Private credit returns and consistency have legitimized the asset class, giving investors a way to diversify beyond the conventional stock and bond mix. It’s no surprise that it has become “one of our high-conviction investment ideas,” according to J.P. Morgan.
Here, we break down the reasons why private credit is an effective way to bolster returns in a long-term portfolio.
Gaining Meaningful Yield at Acceptable Risk
As lending standards have tightened, borrowers have started to look beyond conventional methods of borrowing. For many, private credit is the answer.
The private credit market has experienced considerable growth in recent years. Between 2010 and 2019, the private credit market grew at a 12% average annual rate. Between 2020 and 2022, that number climbed to a 23% annual growth rate. Borrowers, seeking the expediency, certainty of execution, efficiency, and customization available from private lenders, are willing to pay more, and investors are reaping the rewards.
Research from the Institute for Private Capital determined that the IRR across 476 private credit funds with nearly $480 billion in committed capital was 8.1% between 2004 and 2016.
A study by Blackrock also showed that a portfolio with private credit investments generated lower annualized volatility. This analysis used the S&P 500 Index, the Bloomberg US Aggregate Bond Index, and the Cliffwater Direct Lending Index, an asset-weighted index of about 14,000 directly originated middle market loans totaling $295 billion.
Investors can earn better returns than an equity/fixed-income portfolio, and they can do so without taking on substantially more risk. Private credit can also offer the possibility for current income from cash flows provided by interest payments and fees, along with portfolio diversification, providing less correlation with public markets than other asset classes, such as equity and bonds.
Accessing a Growing Market
Between 2010 and the end of 2022, private credit assets surged 460% to over $1.4 trillion, according to data from London-based investment data company Preqin.
Part of what drives this growth is the normalization of financing via private credit. Real estate sectors like hospitality and multifamily are two examples of markets underpinning the strength of private credit as an investment option. Hospitality real estate data from CBRE forecasts that revenue per available room (RevPAR) will rise 3% overall, in particular, “Urban hotels are expected to outperform in 2024, while airport hotels will benefit from the increase in inbound international travelers,” according to their research.
Meanwhile, the Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac, expects to see growth in the multifamily real estate sector “while it works to absorb the high level of new supply in 2024.” Rent growth is expected to grow by 2.5% for the year.
The numbers remain attractive to non-bank lenders given that many loans yield 6 or 7 percentage points over the floating rate benchmark, which is about 11% or 12% in total. These figures are possible because the bespoke nature of private credit, which offers speed and privacy, meaning lenders can ask for more.
Private credit is becoming a more established asset class as more players enter the market. For investors, the timing couldn’t be better. Geopolitical uncertainty, a contentious presidential election, and the heightened risk of global risks like COVID-19 have prompted more people to seek investments not subject to the same kinds of risk experienced by equities and fixed income. As a result, portfolio managers have a way to be more strategic in the types of risk they accept.
Capitalizing on a Higher for Longer Setting
The era of low rates is behind us. The Fed’s pace of rate increases has been the fastest in four decades, putting bank capital at a premium.
At the same time, banks will likely experience more regulatory constraints that could impact their lending ability. The high-profile failures of Silicon Valley Bank, Signature Bank, and First Republic have prompted US bank regulators to move forward with new measures. The rules, referred to as the Basel III endgame, would require banks with at least $100 billion in assets to increase the level of capital they hold. Banks that are considered systemically important would need to set aside, on average, an additional 19% of capital. Banks holding a lower total asset number would be required to set aside a smaller portion of capital.
The bottom line: If this regulation is finalized, banks would need to hold an additional $2 of capital for every $100 of risk-weighted assets.
While these rules are still years away, banks are already retrenching. As a result, lending markets are wide open, giving private capital plenty of opportunities to address underserved needs. As analysts from Pimco explain, “Pricing has become more attractive as available bank capital shrinks and demand for specialty lending rises – the beginning of what we believe will be a secular trend.” Those same analysts believe the most significant opportunities will be in sectors like residential mortgage credit, solar, and home improvement lending.
Demand for capital remains healthy as hopes for a soft landing become a reality. However, much of this demand will not be served by banks as they face liquidity constraints and the looming burden of increased regulations. In this setting, private credit is likely to become more attractive to borrowers and, therefore, lenders who can capitalize on relatively high rates of return with manageable risk.
Engaging in Impact Investing
Private credit is a way for socially-minded investors to participate in impact investing. At the same time, private credit offers borrowers faster, more efficient ways to access capital with more favorable terms than what is available with traditional banks. For example, by sourcing funds from private credit, the borrower often enjoys greater flexibility in the deal structure compared to banks that have onerous, and lengthy requirements.
The benefit to investors is that they know more of the details about the enterprise they’re supporting. In some cases, they may even have the opportunity to invest in a business that’s in their community. As a result, they know they are supporting their local economy.
This approach is more transparent and direct than investing in an ESG ETF that offers the investor no real insight into the specific projects their money is funding.
Benefitting From Transparency
Private credit offers a level of transparency not seen in equities or fixed income. The close relationship between the borrower and the lender is a major benefit in private credit because each side knows that their interests are aligned with the other.
Investors know the details of the projects their committing to. They know details about the borrower’s financial standing. This information not only help the lender make an informed decision that suits their risk tolerance, it also allows them to balance their search for growth with their need to allocate capital to ventures that reflect their personal drivers.
For example, a lender can become part of green solutions by investing in renewable energy projects. This approach is fundamentally different from investing in conventional ESG ETFs or bond funds that don’t allow investors to see the direct and tangible results of their capital.
The conditions for private capital have rarely been better. Forward-thinking investors have an opportunity to seize the moment and diversify their portfolio in a way that generates superior returns without increasing exposure to stocks and bonds.
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At AVANA Capital we provide the funding businesses need to grow. We offer the speed, flexibility, and ongoing support that enables borrowers to put capital to use efficiently. Our 150+ years of combined experience has empowered businesses to succeed in commercial real estate sectors like hospitality, multifamily, as well as and clean energy.
Our high touch approach is what makes us more than a funding source. We develop partnerships with borrowers giving them access to the full range of services we provide.
For more information on investing with AVANA Capital, please contact Cathy Ellsworth, EVP of Investor Relations (cathy.ellsworth@avanacompanies.com)
This article was originally published on avanacapital.com by AVANA Capital. Read the original post here. Accessed on March 27, 2024.
