Sometimes it pays for investors to find sources of income outside the conventional public channels for fixed income securities. Take private credit, for example. With interest rates at record lows and many publicly traded bonds and stocks approaching historically high valuations, private credit has become increasingly attractive to investors because of its total return prospects, steady income and role in diversification.
Geared to middle-market companies, private credit encompasses direct lending, mezzanine finance and distressed debt. It also typically features stricter covenants and larger collateral than many other fixed income securities issued on public markets. Historically, investors have been compensated for private credit’s relative illiquidity with income that has exceeded the yields on levered bank loans or high-yield bonds by about 2 to 4 percentage points.
The market for private credit is a growing alternative to traditional fixed income. The supply of capital is high, with private debt fund managers holding a record $199 billion available for private credit as of June 30, 2016, a 173% surge from $72.9 billion in 2006, according to Preqin. This has been driven by steady growth in private debt fundraising during the past 10 years.
Demand is also robust. The current wave of private credit resurgence sprung from the 2008—2009 financial crisis as the banking industry retreated from many kinds of traditional lending after the enactment of stricter regulation under the Dodd- Frank Act and the global banking accord known as Basel III. Companies with EBITDA ranging from $50 million to $100 million found difficulty obtaining financing from conventional lenders, so they turned to hedge funds and other nontraditional sources of “shadow banking.”
The comparatively high yields of private credit gain luster during periods of unusual volatility in public bond markets such as today. Sellers of private credit offer a “one-stop shop” for buy-and-hold fixed income investments, compared with the uncertainty of pricing and demand in the publicly syndicated markets.
For an investor*, private credit can help diversify a portfolio while complementing other fixed income components such as investment-grade and high-yield bonds. In addition, unlike private equity, private credit can generate income almost immediately. Investors can soon begin receiving income based on current cash yield and up-front fees, which are loan origination fees paid by the borrower. In contrast, the distributed returns on conventional private equity usually kick in after several years, tracing what is known as a “J-curve.”
Moreover, private credit offers opportunities for additional returns, including through prepayment penalties and payablein- kind interest, a non-cash periodic payment that increases the principal amount of the security based on the amount of the interest. In some cases, investors can also gain equity ownership.
Still, private credit is not without potential downsides, including default risk. The earnings of small businesses can be volatile, posing the possibility of late payment or unpaid debts. Also, private credit is often structured as a long-term investment with lock-ups ranging from five to 10 years. Moreover, while posing less risk than private equity, private credit is likely to provide a lower return.
Nevertheless, with careful attention to risk, we believe that private credit can serve within a balanced portfolio as a high-yielding complement to conventional equity and fixed income securities. We encourage clients to view private credit as an opportunistic asset with low liquidity offering steady growth.
To achieve an optimal risk/return balance, we have invested in asset managers that have performed comparatively well in a variety of credit conditions:
Crescent Capital Group. Crescent Mezzanine is a U.S. middle- and upper-middle market mezzanine debt investor focused on companies with EBITDA ranging from about $50 million to $150 million. The companies are backed by private equity sponsors. Since 1992, Crescent Mezzanine’s seven pools of capital have invested approximately $10.7 billion in 183 mezzanine investments. The funds have generated a 13.8% net internal rate of return (IRR)* with a cumulative annual default rate of less than 1%. We recently invested in Crescent Mezzanine Partners VII, a 2016 vintage fund. (Mezzanine debt is the middle layer in a company’s capital structure that is junior to secured senior debt and senior to equity.)
Yukon Partners. Founded in 2008, Yukon Partners is a U.S. mezzanine investor focused on companies with EBITDA ranging from about $10 million to $30 million and backed by private equity sponsors. Yukon targets 85% of its portfolio to mezzanine capital and 15% to equity-related structures. We invested in Yukon Capital Partners II, a 2014 vintage fund.
Private credit can supplement a traditional portfolio of stocks and bonds with expected current cash flow and potential returns similar to equities. It occupies a preferred position in an issuer’s capital structure and thereby offers a foothold against risk in a time of high valuations and financial market instability.
* Private credit may be only available to Qualified Purchasers and/or Accredited Investors.
The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication.
The cumulative annual default rate for Crescent refers to the amount invested of all mezzanine investments that experienced a payment default on the mezzanine securities divided by the total amount invested by the predecessor portfolio, Fund I, Fund II, Fund III, Fund IV, Fund V and Fund VI and further divided by the number of years since the first investment in the predecessor portfolio was made.
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