Private credit refers to loans and other forms of financing that private lenders provide so the debt is not issued or traded on public markets. Also known as direct or private lending, this asset class historically yields around 8.8% annualized returns, handily beating out commercial real estate and more than double that of high-yield bonds.
In addition, private credit is an attractive asset class for investors looking to diversify their portfolios and combat inflation. With banks pulling back from traditional lending, the window of opportunity for high-yield private credit funds has expanded.
It's no surprise, then, that most investors aim to increase allocation to private credit in 2023–the highest of any alternative asset class, according to a survey by EY. Moreover, over 80% of global private credit managers are bullish or cautiously optimistic about the market’s prospects over the next 12 months.
Protection in a downturn
A myriad of forward-looking economic indicators points to a further downturn ahead in the economy, which serves as a reminder that investors need additional downside defenses.
Fortunately, there is significant diversity within the private credit market, and investors can access a variety of strategies. For instance, experienced investors often favor middle-market lending due to its stringent underwriting and stronger covenants that provide added protection in a downturn.
At the same time, opportunistic credit, which involves investing in primary and secondary opportunities across the credit spectrum, also offers an attractive risk/return profile.
In addition, there is a growing focus on "exotic" strategies such as specialty finance, net asset value loans, and asset-backed lending, which provide a diversified set of uncorrelated returns. This helps investors to manage their risk better while enhancing returns over the long run.
Specialty finance comprises three categories: Consumer lending, which focuses on non-prime and subprime loans for consumers; commercial lending, which includes small business loans, equipment financing, and other forms of corporate debt; and niche financial assets like litigation finance and health care receivables.
Some of these are highly uncorrelated to broader market movements. Litigation finance, for instance, offers returns based on idiosyncratic events like the outcome of a legal proceeding.
Net asset value loans are another area for investors to consider. These are loans made against the value of underlying assets like real estate and infrastructure, and some may be backed by hard assets such as ships or aircraft. Asset-backed lending involves securing loans against any form of collateral that has underlying value, from receivables to inventory.
These investments are relatively untethered from public markets, precious in a downturn.
Outperforming bonds in inflationary environments
Analysts at KKR describe that we're entering a “new macroeconomic regime” with higher inflation and lower returns ahead.
Historically, bonds have yielded negative actual returns in inflationary environments, while private credit has seen nominal returns in the low double-digit range. As such, they suggest investors revamp their fixed-income allocations and supplement traditional bond sleeves in a 60/40 portfolio with private credit assets. This will provide flexibility, yield-enhancing characteristics, and more resilient portfolios that can better handle inflationary pressures.
More specifically, the same KKR report suggests a "60/30/10" portfolio, where 10% is allocated to private credit, with the expectation of generating more income than traditional bonds. That said, the fundamentals behind the 60/40 portfolio are no longer as attractive as they once were, and many accredited investors are fleeing to private markets with much greater allocations.
While alternative assets compose just 5% of the average investor's portfolio, ultra-high-net-worth individuals allocate 50% of their portfolios towards alternatives such as private equity and private credit. This asset class has become a long-term investment of choice for many investors, even outside the institutional space.
In conclusion, private credit remains an attractive and resilient asset class that can help investors navigate an uncertain macroeconomic landscape. It offers higher yields than traditional fixed-income portfolios and a more diversified set of uncorrelated returns that can provide downside protection when the economy takes a turn for the worse.