Capitalizing on the growing alternative lending market

Private Credit, a nascent and rising asset class for wealth portfolios but one that is close to ubiquitous amongst institutional investors, can offer stable, high yielding returns and reduced volatility compared to traditional fixed income, says Michael Massarano, Partner and Deputy CIO at Arcmont Asset Management, an investment-affiliate of Nuveen.

In recent years, Private Credit has emerged as a lower volatility asset class that offers investors an alternative to traditional fixed income investments and an opportunity to enhance portfolio diversification via exposure to private credit.

This non-bank financing has become a critical part of the funding ecosystem and has benefited companies that have found financing via banks or other traditional routes less reliable, as regulatory and market driven volatility have weighed on them over time.

For investors, it can offer a diversified source of attractive risk-adjusted returns, it can help reduce volatility and improve the income potential of traditional portfolios, typically through targeting senior lending, primarily to companies operating in defensive sectors and less cyclically exposed industries.

Given these attractive characteristics, the global alternatives assets under management for private wealth investors is expected to grow at around 12% compound annual growth rate (CAGR)¹ over the next decade and wealth investors are only in the early stages of allocating to alternatives.

Core appeal

We believe there are five distinct advantages for investors considering making allocations to private credit in their wealth portfolios to be aware of.

1. Attractive risk-adjusted total returns potential

   Historically, private credit has consistently demonstrated attractive risk-adjusted total returns that are superior to the liquid markets².

   “There has been a consistent margin premium over time compared to the liquid markets, and we do not have underwriting banks in the middle of deals hence can keep the arrangement fees. Over several years on average, yields have remained attractive between 9% and 10% for what is a senior, secured capital structure debt investment³” says Michael Massarano.

2. Lower volatility asset class

   Private Credit offers a lower volatility asset class partly because credit selection is more heavily weighted towards defensive industries like technology, healthcare, education and other resilient sectors that are non-cyclical, compared to other corporate fixed income investments.

   “We also don’t see those periods of extreme drawdown in liquid markets that are driven by macroeconomic or technical factors, that don't reflect the underlying fundamentals of the business. So you have a much steadier portfolio, with lower volatility” he says.

3. Attractive income and cash yield potential

   Attractive income and cash yields are also appealing to investors. Floating rate loans to high quality companies for example, typically offer a quarterly cash interest which can be paid as yield.

4. Natural inflation hedge

   Private Credit offers a natural inflation hedge. European credit loans are floating rate products that are tied to the benchmark Euribor rate. As central banks have raised rates in recent years to counteract inflation rises, the interest rate on the loans typically increases, thus benefitting investors in higher-rate environments.

5. Portfolio diversification

   Finally, private credit is an asset class that offers diversification versus large corporate and institutional loans. Idiosyncratic credit selection further removes the asset class from performance of the broader credit markets.

   There is also low correlation to other alternatives, such as Private Equity. “We are investing in the same underlying assets but at a senior, secured level in the capital structure, so when investors see year-on-year volatility in private equity as valuations fluctuation, it does not necessarily affect Private Credit,” says Massarano.

   Generally, these five benefits are appreciated by institutional investors, a fact reflected in the strong fundraising over more than a decade.  For the wealth channel, where Private Credit is more nascent in Europe, several features like the cash yield could make for an even better fit.

   We believe that historically it's been a lack of access point and structuring that has restricted the ability for the wealth channel to allocate, not because the asset class isn't well suited to portfolios.

Market dynamics are supportive of growth

Since 2013, European Private Credit has been growing at around 20% CAGR and is projected to grow to around €650bn by 2027⁴.

There are several trends driving growth of the asset class including constrained bank lending for new loans to middle-market borrowers and the steady decline of the number of credit institutions in the EU.

As a result, private credit has emerged as the key alternative source of capital and now accounts for around 60% of mid-market leveraged buyout lending versus zero 10 years ago⁵.

In contrast to the constraints in the supply of credit, demand has been consistently growing. Merger and acquisition activity in Europe has rebounded from 2009 lows and has been growing around 5% CAGR since⁶.

“Private equity continues to significantly grow, with dry powder currently four times larger than dry powder of private credit. That is underpinning the supply of deals for our market, suggesting a material runway for further growth,” Massarano says.

“There's also more than €25bn of loans maturing in the European market, a ‘refinancing wall’, over the next 2 years. The demand for credit continues to grow consistently.

Private credit has long been the beneficiary from this supply and demand imbalance, and we expect that to continue going forward,” he says.

Democratization and innovation

Massarano expects that democratisation will be a key theme as the broader investor base is able to access the asset class. Traditionally liquidity has been a concern for wealth investors, however recent product innovations are tackling these constraints.

“This is the type of asset class that we believe investors should still be thinking about as a long-term investment, albeit now we can provide liquidity for those that need it,” says Michael.

Arcmont Asset Management has received regulatory approval to launch a Long-Term Asset Fund (‘LTAF’) providing an element of liquidity to investors. The LTAF was the first offered by a specialist Private Debt asset manager.

Dispersion in performance

As with any growing asset class, there is likely to be continued dispersion in performance across private credit managers in the coming years.

Historically, a small sub-set of established managers have raised almost 50% of total capital, and for investors, this bifurcation of larger and small managers is something to take note of⁷.

“We believe that investing in private credit with those leading managers that can demonstrate cycle-tested processes and returns, with a track record of returning capital to investors, remains an attractive and stable investment as the macro environment continues to evolve,” says Massarano.