KKR is betting private credit will be one of the best performing alternative investment categories over the next five years. But the asset manager is warning investors that defaults will also rise as the outlook for the economy remains uncertain.
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Private Credit Will Offer Some of the Best Returns in Alts — But Defaults Will Rise
Private lenders are being “chased by borrowers who are happy to pay a premium for scarce financing,” according to KKR.
The compound annual growth rate for private credit is expected to be 11.1 percent between 2023 and 2028, up from 7.5 percent between 2017 and 2022, according to KKR’s latest letter to credit investors. The alternatives firm, which offers private credit, private equity, real estate and other illiquid investments, expects some sub-sectors, such as junior debt, to have CAGRs in the mid-teens over the next five years.
KKR isn’t bullish on stocks; it expects the annual growth rate of the S&P 500 index to decrease from 9.6 percent during the last five years to 5.2 percent between 2023 and 2029. For the same time periods, the CAGR for private equity is expected to drop from 16.4 percent to 12 percent, with unlisted real estate declining from 10.3 percent to 8.7 percent and infrastructure moving from 10.3 percent down to 8.3 percent.
“We believe credit offers a better risk-return proposition than equities in the near term due to the combination of higher yields, debt’s position in the capital structure, the contractual nature of returns in credit, and the pressure equity valuations are under as long as rates remain elevated,” according to the report.
KKR believes private lenders will increasingly fill the financing gap as traditional banks remain under pressure. Because liquidity has become harder to come by, private credit funds are now being “chased by borrowers who are happy to pay a premium for scarce financing,” according to the report. In Europe, over 50 percent of new loan issuance in the third quarter of 2022 was provided by direct lending groups, according to KKR’s estimates.
Even the recent banking crisis shouldn’t disrupt investors’ confidence in the private credit sector, according to KKR. “One of the reasons we can be so optimistic about the prospects for lenders is that we don’t think the issues roiling the banking sector point to trouble in credit fundamentals, but rather a combination of wavering confidence and an asset-liability mismatch,” according to the report. It pointed out that Silicon Valley Bank was an outlier in the banking sector because a high proportion of its deposits was uninsured. “Looking at the overall banking system in the United States and Europe, it is clear to us that this is a liquidity crisis, and not yet a credit crisis,” the report said.
But the collapse of SVB should serve as a reminder that investors should still play defense, according to the report. It suggests investors look for opportunities in high-quality businesses with stable cash flows and defensive margins.
“We do think it is imperative that investors learn to tune out the lure of cheap valuations until they understand whether there is value in the price or if the price reflects the value,” the report concluded. “The world is still uncertain in many ways. It seems likely that borrowers are going to come under increasing stress as central bank tightening slows economic growth, and we expect defaults to rise.”
