High yields from private credit are no free lunch
Investors are being sold the idea of high income and stable returns from private credit. Some of the world’s biggest financial institutions seem skeptical.
It always pays to be careful when people ask to invest your money. And if history is a guide, it pays double when an asset class goes from being the realm of institutions and high-rollers to being pitched at everyday investors.
I think it’s fair to say that private credit funds have moved into that territory now. Here are the first two paragraphs from an AFR article on June 7. The article’s title was “Fortunes to be made as the private credit boom is going public”.
“It’s a winning trade that is being pitched around the world to investors of all sizes – from little old ladies to sovereign wealth funds…
The opportunity is earning double-digit returns by lending money to small businesses, big companies and real estate developers that have been left hanging by the banks. Lending money is reliable, stable and thanks to higher interest rates, is a compelling investment.”
I think a lot of people would find ‘reliable’, ‘stable’ and ‘double-digit’ yields attractive - hence why pretty much every private credit fund makes this same basic pitch.
High yields without the volatility. Better yields and less downside risk than public bonds. And did we mention the double-digit yields with less volatility?
My gut – not to mention several episodes from financial history – suggest that these high yields are no free lunch. But we should probably start by establishing what private credit is.
I decided I needed some help with this, so I asked a prominent Australian private credit investment firm, Metrics, to explain it to me in simple language. Their managing partner Andew Lockhart said:
“Private credit funds raise money from investors and lend it directly to medium to large-sized companies in a similar manner to banks. Investors in private credit earn regular income generated from the interest and fees paid by those borrowers on their loans, less fund costs.”
So, private credit means investing in loans of the sort usually made by banks. These loans could be to companies or projects that are too small to raise money in corporate bond markets. Or borrowers that are seeking loans banks can’t or won’t take on. Or borrowers that, for whatever reason, prefer to lend from a non-bank lender at higher rates.
As there is no liquid market for these loans, they are usually held until the debtor pays back the principal. In the meantime, those managing these investments distribute the interest payments received to investors.
Huge growth in the asset class
Private credit has grown rapidly since the great financial crisis.
This chart from Morningstar division Pitchbook’s Annual Private Credit Report shows you the US dollars allocated over time:
The story goes that banks have stepped back from this kind of loan because of tighter lending regulations. Other entities – the private credit firms – filled the void and were able to charge attractive interest rates. These rates are usually floating and priced several percentage points above risk-free rates.
When you consider that we just went through nearly a decade of ultra-low interest rates, it is no wonder private credit attracted huge interest from pension funds and institutions.
Australia’s biggest super funds have not missed out on the party. Cbus and HostPlus’s default MySuper options have grown their unlisted credit allocation to around 7% at the time of writing. Australian Super has around 4.5% allocated but has publicly stated its intention to ramp this up.
These three funds are not outliers – big super loves private credit, and this is often used as proof that smaller investors should be piling in.
Private credit’s three big claims
Everyday investors haven’t traditionally had much access to private credit. But the advertisements are starting to come through en masse.
Most private credit pitches I’ve seen pivot on three claims:
• Yields you can’t get anywhere else
• Lower downside risk than equities and corporate bonds
• Stable returns
Let’s see how these claims stack up to common sense, episodes from financial history and research conducted by the International Monetary Fund (IMF) and the Federal Reserve.
While the research carried out by the IMF and Fed might not cover the Australian market specifically, I think it aligns with assumptions we can reasonably make about private credit borrowers more generally.
Claim 1: Yields you can’t get anywhere else
Andrew Lockhart from Metrics said that “more conservative” private credit funds can deliver yields of 6-9% per year, while other funds can offer “10% to 13%”. The former could be seen as an alternative to cash or lower yielding bonds, while the latter may be viewed as a potential alternative to dividend stocks.
As I write, the 5-year Australian bond yields just over 4% if bought today and held until maturity. As of June 28, the S&P Australia IG Corporate Bond index yielded around 5.4% and the high-yield equivalent yielded 7.3%. I have no doubts that this differential in yields will sound attractive to retail investors.
I think it’s worth asking, though, why such high yields are available. The answer, in my view anyway, appears quite simple. The higher potential returns stem from taking more risk.
Consider this chart the IMF featured in an article titled “Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch”. It compares the size (by total assets) and indebtedness of private credit issuers to corporate bond issuers in the US market.
According to this data, the median firm utilizing private credit finance in the US is 10 times smaller than the median sized high-yield issuer and 32 times smaller than the median investment-grade bond issuer.
Chart Source: IMF, Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch
Smaller firms typically have less access to other sources of funding, less diverse product ranges, less geographic diversification or products and services that are still unproven. This can make these companies riskier to lend to, hence higher interest rates being needed to compensate.
Data from that IMF article and the Federal Reserve’s research paper Private credit: Characteristics and risks also suggest that private credit borrowers rank significantly worse on many measures of creditworthiness.
The IMF chart above shows that private credit lenders generally had more outstanding debt relative to their earnings than public bond issuers, albeit with a comparable debt-to-assets ratio to investment grade companies.
Meanwhile, the Fed’s research pointed to lower interest rate coverage. According to data the Fed’s researchers sourced from KBRA DLD, the average private credit borrower earns only two-times more annual profit than it pays in interest. As you might expect, the level of coverage fell significantly from 2022 as interest rates rose.
Chart Source: Federal Reserve, Private Credit: Characteristics and Risks
The interest coverage ratios in the Fed’s sample shows a far smaller buffer than the levels predicted by Fitch Ratings’ outlook for global investment grade companies (10.1x) and global high yield issuers (4.7x) in 2024.
I don’t think private credit funds shy away from the fact that they are lending to smaller and riskier borrowers. But I do think the whole narrative that “banks stepped back and we filled the void” could distract investors somewhat. Higher risk is also a big part of the equation.
Another narrative you’ll hear is the idea that private credit isn’t really a new asset class at all and is simply a continuation of lending that banks have been doing for centuries.
My main issue with this narrative is that non-bank lenders are essentially unregulated. The environment in which they are making loans is clearly very different to the ones that banks have operated in. Also consider that banking regulations are there for a reason – history is littered with banking crises that caused a lot of instability in society.
Will private credit’s growth make it riskier?
As we saw earlier, the amount of money allocated to private credit is a lot bigger than it was ten years ago. A lot of that money is still waiting to be lent. This is known as “dry powder” and is shown by the dark blue portion of the bars in this chart:
Fund managers are incentivised to deploy this dry powder quickly. Not just because they have promised to invest this money and generate returns for their clients. But because it increases their chance of collecting higher fees. You can’t collect a performance fee on cash.
If history is a guide, there is a risk that managers may find themselves lowering lending standards in a bid to lend more money. Especially if the promise of ‘high and stable yields’ whips up a new wave of demand from retail investors.
An extreme example comes from the case of Michael Milken, who virtually created the market for high-yield bonds in the US. In the end, he was so successful in creating demand for high yield bonds that he needed to stretch further and further to find new companies to issue debt. He was able to do this because you can always find someone willing to borrow money. The key is to make sure they can actually pay it back.
I’m not saying that is necessarily going to happen with private credit. I’m just saying that we have seen similar situations play out this way before.
Now let’s consider the next benefit often touted by private credit funds: elements of lower downside risk.
Claim 2: Lower downside risk?
We’ve just learned that, on average, private credit borrowers are less creditworthy than public bond issuers on several metrics. Despite this, you will often see pitches touting the potential for high returns with elements of lower risk than bonds and equities.
This claim usually leans on three core arguments:
1. Private credit has historically shown lower default rates
2. Most private credit loans have senior positions in the capital structure
3. Higher interest rates could be a positive, not a negative
Let’s start with lower default rates – the percentage of borrowers that fail to keep up with their interest or principal payments.
KBRA DLD, which gathers data on private markets, estimates that private credit’s default rate during 2023 was 1.7% for direct lending and 5.8% for syndicated loans. The 1.7% default rate for direct lending stands out. Why? Because it is far lower than S&P’s estimate of a 3.5% default rate for global high-yield corporate debt during 2023.
This lower default rate occured even though private credit borrowers generally rank below high-yield issuers on key measures of creditworthiness. How can this be?
The Federal Reserve paper offered up that private credit borrowers have more scope to renegotiate with the lender when things get tight. This makes sense because there are fewer parties involved in the deal and fewer people to please.
The economy was also far stronger than expected in 2023, especially in the US – and I’d suggest that strong demand for private credit has probably made it easier for struggling firms to refinance instead of default.
Andrew Lockhart from Metrics offered another potential explanation: because they are originating the deals themselves, private credit managers get far better access to information than credit rating agencies do. This could put them in a better place to assess deals and arrive at terms that protect the borrower, even in a worst-case scenario.
All things considered, I think it is unlikely that smaller and less creditworthy companies continue to default at lower rates than companies big enough to issue corporate bonds. This would be even more surprising in a prolonged economic downturn, something today’s private credit asset class is yet to experience.
This means that investors are heavily reliant on the manager to pick the right borrowers.
There is no credit rating agency to assess credit worthiness. There are no bank regulators to impose standards and capital requirements. It is all up to the skill and standards of the manager. Since there is generally very little transparency into the loan book, there’s a risk that investors won’t know that anything has gone wrong until it is too late.
Claim 3: Higher debt seniority = less risk?
In most cases, private credit loans have high seniority. This means that in the event of a bankruptcy these loans will have first priority on the collateral sold to make lenders whole (or less un-whole).
This feature of private credit loans basically implies that the risk of higher default rates could be offset by higher recovery rates.
The Federal Reserve’s study, however, suggested that direct lending (the most widespread form of private credit) sees lower recovery rates than high-yield bonds after a default – as shown in the two groups of bars furthest to the right.
Chart Source: Federal Reserve, Private Credit: Characteristics and Risks
The Fed pointed out that the funds in their study were overweight in asset-light industries, which could be a factor. There were simply less assets to claim on once a loan had defaulted. I also wonder, though, if it’s a sign that being higher up in the ‘capital structure’ means less when you are loaning to smaller companies.
If you are the only lender, touting that you are top of the capital structure is a bit like claiming a gold medal in a race of one. The most important thing isn’t really the position itself, but what assets that position gives you access to should you need it.
Attractive loan terms could still more than compensate for higher default rates and lower recovery rates. After all, that is the whole game here – every deal must be researched and structured well enough to put the probabilities on your side. Now let’s move on to the next supposed positive of private credit.
Higher interest rates = good?
The third reason given for private credit’s purported safety is that inflation and higher interest rates may not be a bad thing for the asset class.
Publicly traded debt assets (like bonds) respond poorly to rising interest rates. This is partly because the fixed yields on these bonds become less desirable when higher risk-free rates become available. Except for when a bond is just about to mature, this situation will be corrected by the bond’s market price falling to offer investors a higher effective yield.
As most private credit loans have floating interest rates, income collected from the loan portfolio will rise in tandem with interest rates. But I’d be interested to see how much of this benefit was snuffed out by higher default rates.
The Fed’s data suggests that fairly low interest coverage ratios are the norm. If higher rates do eventually slow the economy, what happens when these companies see their revenues fall? The borrowers’ interest coverage could be squeezed from both ends. Now let’s move the last leg of the trifecta: the promise of stable returns.
Claim 3: Stable returns
The reason that returns for private credit are potentially more “stable” than other income sources (like bonds) is simple: the loans themselves are not publicly listed.
By contrast, publicly traded bonds move every day and a portfolio’s value can be ‘marked to market’ at a price the holdings can actually be sold at. The price of fixed rate bonds in the public market will mostly be influenced by two things:
1. Interest rate expectations. If expectations for risk-free rates go up, the price of bonds issued at lower fixed rates go down to compensate for that.
2. Confidence in the company’s ability to meet its obligations. This is usually driven by company updates and the research and ratings published by credit rating agencies.
As we just mentioned, private credit is mostly floating rate debt and therefore its value may not have the same sensitivity to interest rates as fixed interest bonds. But the value of these credit assets still depends partly on the borrower’s chances of meeting their obligations.
In other words, the lack of a market quote doesn’t change the nature of the asset itself. And if a fund’s valuations and entry/exit prices on a given day don’t reflect economic reality, somebody is getting screwed on the way in or the way out.
The difficulty and cost of valuing these assets regularly – not to mention the incentive for managers to report high carrying values – makes me wonder if this asset class is suitable for retail investors. It’s just so opaque by nature.
Leave it to the big dogs?
I’m not saying that private credit is going to implode tomorrow. All I’m saying is that the high, stable, reliable yields being offered are unlikely to be a free lunch.
The high yields on offer are simply a result of taking on more risk. The ‘stability’ might be due to a lack of transparency more than economic reality. As for ‘reliability’, I guess we’ll see what happens when we get a real downturn.
If managers can do a good job of ensuring that loan terms and the quality of their due diligence offsets these risks, their investors can still do well. A big part of this will be resisting the temptation to loosen their underwriting standards, even if strong demand for investing in private credit nudges them to simply find as many deals as possible.
Overall, I can’t help but feel that everyday investors might be best leaving this one to the institutions. Big super and pals have the scale to diversify more suitably. They will also have more insight into the loan origination process than an everyday investor.
Big super’s love of private credit might be enough of a reason for everyday investors to steer clear anyway. Advertisements might imply that you are ‘missing out’. There’s a good chance you have plenty of exposure already.