Opening private credit to more of the public

Private credit is a privately negotiated loan between a borrower and an asset manager, and investors can purchase it in a private Business Development Corporation (BDC), a public BDC, a drawdown fund or in a separately managed account wrapper. For more than a decade, private credit has significantly outperformed liquid credit or fixed income on a total return and volatility basis. These qualities are the reasons why replacing fixed income with private credit should improve the total return and Sharpe ratio of an investment portfolio. The Cliffwater Direct Lending Index (CDLI), which measures private loan performance and is often used as an industry benchmark, currently shows an 11% yield to maturity — more than a 500bps spread to U.S. investment grade credit, CMBS and U.S. Treasury securities — and a 400bps spread to high-yield corporates. Additionally, private credit has generated positive returns each calendar year since 2008.

The total addressable market (TAM) of private credit has expanded from non-investment grade up into investment grade and down into junior securities, and from loans to corporations to asset-backed finance, infrastructure and real estate debt. The largest private credit asset managers have evolved into one-stop shop platforms that have taken significant share from banks and other non-bank lenders while their products use leverage provided by the banks. In fact, most of the middle-market, non-investment grade corporate lending has shifted away from the banks to the asset managers, while asset-backed finance is still in the early innings of migrating. Additionally, we view all three major client channels (retail, institutional, insurance) as underallocated to private credit globally, which supports our bullish 10-year outlook for private credit. And although private credit AUM is becoming sizable in the U.S., the industry is still immature as an asset class in Europe, Asia and Latam, which provides for a long runway for growth.

The credit quality of private credit has been solid for a long time. However, in the future, an economic recession could trigger a spike in loan defaults. Accordingly, if we assume a very adverse economic scenario where defaults rise to 10% of the entire portfolio and apply a 50% loss severity assumption, a private credit portfolio could incur a 5% loss in a calendar year. This is more than 20 times greater than the current loss trends. However, these portfolios are currently yielding 11%, so a 5% loss would still equate to a positive 6% return in that calendar year. In this sort of economic scenario, we assume the stock market could correct by 40% or more. In our view, a bad economic backdrop would actually serve as a strong advertisement for the relative performance advantage and downside protection qualities of private credit.

With the aging of populations and an increasing number of retirees in many developed markets, including the U.S., Western Europe and Japan, we believe private credit fits perfectly in their portfolio given the high cash yield combined with downside protection relative to public assets. Additionally, some of the U.S. private credit products pay a monthly distribution that matches more closely with the living expenses of a retiree versus other products that make quarterly distributions. The allocation to private credit in the U.S. IRA and 401(k) channels is currently zero, and we believe a substitute for public debt would significantly enhance the return of U.S. retirees. Under the Trump administration, the industry has been lobbying to allow regulators to open up the $13tn U.S. retirement channel to privates. The U.S. retirement opportunity could be sizable given the current zero allocation to these investments.

Rather than own the actual BDC, we see more long-term value in the manager of the BDC given the faster growth trajectory. The managers that are best positioned are the large cap U.S. Alternative Asset Managers that operate private credit businesses that expand across asset segment (corporate, asset-backed, real estate, infrastructure) and up and down the capital structure. They raise funds from all three channels (retail, institutional, insurance), and many have set up long-term agreements with insurance companies to help manage their general accounts. We also highlight that the private credit asset class behaves defensively as deployments outperform in market corrections, and the profit stream is also more defensive as it has a lower composition of lumpy, performance fee revenues.