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The Premium in Private Credit Has Disappeared. That’s Not Stopping Allocators.
The war in Ukraine marked a turning point as high-yield issuance came to a halt and private equity turned to direct lenders to fill the void.
Investors aren’t getting a bump for putting their money into private credit rather than public securities, but many are shrugging it off. The yield parity between the two comes after steep declines in the public markets.
It’s not just that allocators’ current commitments to private credit funds are locked up for years. Many investors are ponying up new money for private credit, even as the decline in liquid markets has created better opportunities than they’ve seen in years.
Generally, allocators get 2 percent to 3 percent more to invest in private loans to middle-market companies over public debt. That’s the so-called illiquidity premium for not being able to sell holdings easily. “Today it’s gone,” said Jonathan Bock, CEO of Barings BDC, commenting on the spread benefit relative to liquid loans. “Liquid markets are at 86 or 89. That’s a fat yield. You’ve got quite a bit more oomph there.”
But a critical mass of investors isn’t biting at the fat yield. Bock told Institutional Investor that part of the reason is that private credit deals are a long-term investment. Private credit managers find lending opportunities and convert them into investments. Picking up securities at a discount as the world worries about inflation and recession? Well, that’s a trade, he says.
Pensions and endowments can make that trade and sell securities as the world heals. But as one CIO told II, there’s still a lot of uncertainties to be resolved, and the only option when things sour is to sell. The CIO said liquidity in public credit markets can be fickle anyway. “Everyone knows it dries up when you really need it. Sure, you can sell at any time…but at fire-sale prices.”
Still, the ability to get very similar returns in public markets, to be able to sell on a dime, and to get access to the debt of larger companies that are often more stable during a recession is appealing. One public pension CIO said he’s maxed out on private credit. He does have a pool of cash available for opportunities such as those he’s seeing in liquid credit, but he has yet to put that money to work. “It still may be too early,” he said.
If it’s hard to time public markets, it’s essentially impossible in private credit. That can work in investors’ favor.
“It’s hard to time entry and exit into illiquid asset classes,” said Adam Wheeler, co-head of global private finance at Barings, responding to a question from CEO Bock during a Barings’ client webinar last week on public and private credit.
“We’re driven by fundamentals, rather than by [the] technical factors you see in public markets that [allow] you to time.” Comparing private credit markets to a slowly turning ocean liner, Wheeler said he’s lending money now and taking advantage of better pricing, stronger covenants, and lower leverage. The turning point was Russia’s invasion of Ukraine. High-yield markets shut down, and private equity firms turned to the direct-lending markets to fill the void. “The repricing of risk…compensates for the different market conditions we’re living in,” he said.
Given the economic outlook, he expects these conditions to persist and to set the funds up for outperformance over the next year or two. “Probably two or three, to be honest,” he stressed. The idea is to deliver a consistent return when times are good and when times are bad.”
Private credit focuses on smaller companies; Barings invests in middle-market companies with an average of $30 million in EBITDA. Wheeler said that safety in private credit comes back to selecting assets. “There are certain sectors we don’t invest in. We have the luxury of not worrying about the index. That’s very different from a high-yield fund.” Or as Bock put it, “We focus on ‘boring is beautiful.’”
The environment for private credit in the U.S. and Europe has also changed. In recent years, Europe has delivered slightly higher absolute returns than the U.S. But now the return profile between the two markets is quite similar. That’s “kind of unusual,” said Wheeler. Unlike in the U.S., mid-market direct lenders compete with banks in Europe. “Those banks have pulled out at the moment, so we have less competition in Europe,” said Wheeler. But the U.S. market remains far bigger and broader, offering more choices.
Wheeler, like many in private credit, expects a shakeout over the next year or two as performance starts to diverge between managers and the risk taken before the downturn is reflected in portfolios.
As Bock put it, the managers that threw caution to the wind won’t have the lending capacity to jump on the deals now available. “To take advantage of this market opportunity, you have to have been disciplined over the last few years,” he said.