In focus

How private credit enhances returns while lowering risk


Private assets have been popular with endowment funds and large institutions - including sovereign wealth funds and government pension plans - for some time. However, more recently private assets have been attracting increasing interest from other institutional investors, such as defined benefit pension plans and family offices.

Interest in private credit, in particular, has grown significantly. In 2013 only 2% of European pension funds had an allocation in this area. That figure has now grown to 16%. Allocations are still low, but growing, as investors have sought out the potential to earn a return pick-up over traditional fixed income. Importantly, private credit is also no longer just for large institutions.

Higher credit spreads are eye catching

The initial reason that many investors are attracted to private credit is the ability to earn a yield pickup over traditional fixed income instruments. Whereas investment grade corporate bonds have been offering credit spreads of 1.0-1.5%, it has been possible to earn 2.0% or more in senior infrastructure and real estate debt (both of which share characteristics with bonds of investment grade rating).

Similarly, while credit spreads on high yield bonds have been 4.0-5.0%, junior infrastructure debt offers on average 4.5% and senior mid-market (corporate) senior direct lending in the US and Europe between 6.0% and 8.0%.

This additional credit spread is due to a number of factors but is often described in simplified terms as an “illiquidity premium”. In its simplest terms, this is compensation for the fact that private credit involves investors locking money up for several years at a time, while a corporate bond can be sold relatively easily (although this can be tested in times of market stress).

In reality, the magnitude of the additional return offered by private assets is not due solely to illiquidity but also to other factors like transaction size, complexity and the deal sourcing ability of an investment manager. In most cases, it is impossible to disentangle these different drivers, but it is important to be aware of their existence.  

Risk reduction seals the deal

Private credit can offer something which is just as valuable to pension funds and insurance companies as higher yields, if not more so: the potential for greater certainty of returns, due to lower credit loss rates.

Many sectors have historically been exposed to a lower risk of loss than equivalent-rated public market bonds. This is driven by two factors:

  1. Lower average default rates
  2. Higher average recovery rates

Default rates are linked to the credit risk of the underlying asset or project being lent against. Infrastructure exhibits the greatest cash flow stability and a notably lower risk profile than corporate bonds. Real estate can also be lower risk than corporate bonds, especially now that financing structures are more conservative than before the financial crisis.

Real estate and infrastructure debt also come with the advantage that they are normally secured on physical assets such as telecommunication towers, power generation facilities, office buildings or warehouses. Importantly, the secured nature of infrastructure and real estate debt means that, in the event of a default, a ring-fenced asset or assets can be sold and the proceeds used to repay the lender. This boosts recovery rates and limits losses. Recovery rates for infrastructure and real estate debt average around 75%, substantially more than the 40% level typical on corporate bonds.

Loans to small and mid-market companies is generally comparable to high yield bonds and is attributed with “sub-investment grade” risk but the universe is highly diverse. Although mid-market loans do not typically have ring-fenced assets, recovery rates have also been relatively high, with an average of 80% achieved.

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Private credit is no longer just for large investors

If private credit sounds so great, why do almost 85% of European pension funds not have any allocation to this area? There have been two major deterrents: governance burden and access. These are particularly challenging for smaller investors.

However, innovation in product offerings mean that it is now possible, even for smaller investors, to gain access to a diversified private credit portfolio. This can be achieved by working with a credible partner, who in turn is able to access top performing funds and pool individual investments to scale. Then, the only governance burden is in selecting and monitoring a single manager rather than several.

By pooling investments it is also possible to gain access to funds that would otherwise have been out of reach. That scale can also result in these investments being possible at a lower cost than would be open to individual investors.

 

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