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Pursuing Opportunities in an Illiquid Asset Class
An Institutional Investor Sponsored Report on Private Credit and Specialty Loan Strategies
By Richard Westlund
Private credit offers a variety of opportunities for institutional investors, particularly those with long-term time horizons. A variety of strategies is available to match fixed income assets with liabilities, capture a return premium, or pursue high-yield options. In any case, the private credit sector can bring stability and diversity to an investment portfolio.
In contrast to publicly traded bonds, private credits are relatively illiquid, so investors typically follow a buy and hold strategy rather than a total return trading strategy, says Chris Lyons, managing director and group head, private credit, Voya Investment Management.
“Most insurance companies have liabilities with 5- to 10-year durations, so an asset class with a similar duration that provides fixed income and covenant protections aligns well with their goals,” says Lyons. “Pension plans are also natural buyers for private credit, which typically returns 80 to 100 basis points a year over public debt.”
While private credit means different things to different investors, this asset class includes broadly syndicated loans, infrastructure loans, corporate private placements, and middle-market loans. “We think of it as assets that are not freely traded,” says Eric Lloyd, head of global private finance, Babson Capital Management. Both investment-grade and non-investment-grade products are available, including loans whose rates can be adjusted in the event of inflation.
Lloyd has seen an increase in interest in private credit from investors seeking to pick up an illiquidity premium by allocating a portion of their fixed-income portfolios in this sector. “The type of private credit varies by investor because each portfolio is different,” he adds.
“The credit cycle has shifted into a period of higher volatility, rising defaults and potentially rising rates,” says Ken Kencel, president and CEO of Churchill Asset Management, a TIAA-CREF company. “Now is a good time for investors to consider private credit, assess the sub-asset classes and determine which strategies best match their goals.”
Weighing the options
Private credit investors need to understand the nuances of allocating to this sector as well as the various risk-return profiles. That’s because loans offering similar yields could come with significantly different levels of risk, says Kencel.
“Broadly syndicated loans are floating rate loans made to large-cap corporate borrowers,” Kencel says. “A broadly syndicated loan may have 15 to more than 100 investors in a senior credit facility, the vast majority of whom are mutual funds or collateralized loan obligations (CLOs).”
That’s a different structure from middle market loans, which are typically made by a small number of co-lenders in a “club” structure where the lenders know each other and cooperate closely, he adds. “Middle-market senior loans offer better overall terms, along with a yield premium of 100 to 200 basis points,” Kencel says. “They have traditional financial covenants that provide mezzanine loans or other types of junior debt.”
Noting that Churchill focuses on traditional middle-market senior lending, Kencel says loans that go deeper into the capital structure typically carry a higher risk, as do senior loans to small companies that are less able to withstand a downturn in the economic cycle.
Lyons says Voya’s private credit portfolio runs from investment-grade through triple CCC loans. “While investment-grade private credits offer more yield and better downside protection, we also hold high-yield, middle-market and mezzanine loans,” he says. “We also provide credit to smaller companies, typically $75 million and below, that are trying to build their business and grow to the next level.”
In the high-yield sector, Lyons has seen a pullback in bank lending, allowing Voya to focus on club deals with a handful of other large investors rather than organizing a syndication. “Having a club arrangement has other advantages compared with syndication,” he adds. “Having fewer lenders means you have an opportunity to get better deals on the front end and manage the credit more effectively over the life of the loan.”
Lloyd points out that investment opportunities exist throughout the capital structure, from traditional senior secured and second-lien loans to mezzanine debt with equity features. In the U.S. and Europe, Babson has seen growing interest in unitranche structures, which combine characteristics of senior and mezzanine debt.
Minimizing the risks
Because private credits are long-duration, illiquid loans, they require extensive due diligence. “We pay attention to macro trends, including political, economic and interest rate risk,” says Lloyd. “However, our investment process begins with a bottom-up credit analysis looking at companies with strong fundamentals in stable industries.”
Lyons notes that underwriting is significantly deeper – more in keeping with a bank loan than a public bond. “It involves spending more time with management, making site visits, and developing a relationship,” says Lyons.
One of the keys to minimizing risks in middle-market loans is incorporating strict financial covenants that are similar to a bank loan, such as maintaining a certain debt to cash flow ratio, or forbidding the sale of business assets. In fixed-rate loans, the credit agreement also can include an adjustment if interest rates rise.
“Investors should look to lenders who understand the importance of traditional financial covenants,” says Kencel. “If a company is underperforming, the lenders can bring management back to the table and address those issues in advance of a payment default.”
Lyons agrees, adding that the inclusion of covenants is one reason losses are lower with senior secured loans and with public bonds. “On the other hand, if the company performs as expected, we can do follow-on loans, continuing our relationship with the company just like a banker,” he adds.
Advice for investors
Professionals who focus on the private credit sector have several suggestions for institutional investors:
- Think globally. “A strategy that includes assets from different geographies provides a larger funnel for the fund manager who can look across regions in an effort to maximize opportunities, says Lloyd. “Some investors may prefer a U.S. or a European private credit strategy, while others want to connect these strategies across different regions.”
- Combine public and private credits. One strategy that appeals to many institutional investors is a combination of liquid and illiquid credits, says Lloyd. “That strategy provides exposure to the credit market without the pressure of finding suitable private credits immediately,” he adds. “An investor could access the liquid market first, and transition part of that portfolio to the illiquid side based on an assessment of relative value.”
- Look at your position in the capital stack. “As part of the due diligence process, you should look at the average equity contribution in the manager’s transactions,” Kencel says. “You also should understand how much junior capital is in the stack below you and look at the overall leverage.”
- Analyze the projected return. “Investors should be sure the private credit opportunity meets the desired risk-return profile,” says Kencel. ‘If returns are in the 9 to 10 range, the lender is operating in a higher-risk segment compared with middle-market senior loans.”
Finally, investors should do their homework to be sure they understand all the characteristics of the private credit, as well as the risk profile of the manager. As Lyons says, “Be sure you are getting true transparency.”