Investing on an integrated and holistic basis across a range of private credit sectors should bring benefits for investors.
A changing landscape
Opportunities for investing in private credit have expanded dramatically in the last ten years. This is providing investors who are able to sacrifice some liquidity with access to higher yields, an improved risk profile and exposure to less correlated economic drivers. However, as the market continues to develop, building a diversified private credit portfolio by incrementally adding sector-specific sleeves is not only inefficient from a portfolio construction perspective, but also limits the opportunity set for all but the most sophisticated institutions. We argue for a new approach to investing in private credit.
Death by a thousand cuts
Banks have a long history of losing market share. Four millennia of dominance in extending credit was first challenged in the 17th century, when the Bank of England turned to the public with the first official government bond issue and the Dutch East India Company issued the first-ever corporate bond. The process of disintermediation continued with the advent of the high yield bond market in the early 1970s and the creation of the structured credit market in the decades that followed.
Further challenges to banks’ market share then came from private lending based on direct relationships. In the wake of various banking crises – notably the US Savings and Loan Crisis in the 1980s and the Global Financial Crisis in 2008 – financial weakness and increased regulation stripped market share away from banks in favour of institutional investors able to originate loans directly, on a private basis.
Adapting portfolios to changing markets
The evolution of the public bond market led investors to redefine what such a market actually constituted, taking into account the growing breadth of issuer types - and, specifically, their varied investment attributes and performance characteristics. As investors came to recognise that performance across issuers was often driven by common risk factors – chiefly changes in risk-free rates and credit spreads – they began to oversee their bond investments in a more coordinated way, mitigating the proliferation of separate ‘sleeves’.
As with public bonds, the development of the private credit landscape proceeded unevenly, with different areas accessible by institutional investors at different times. But over time, ‘private credit’ came to represent such diverse areas as commercial real estate debt, infrastructure debt and direct lending (mid-market corporate debt), and an extending tail of types of ‘speciality finance’.
Today, as sophisticated institutional investors look to avail themselves of the increasing range of opportunities in private credit, the proliferation of separate investment ‘sleeves’ requiring oversight is becoming unmanageable. It also precludes the application of basic principles of good portfolio management.
Private Credit 2.0
Investors need to break down these ‘silos’ in order to ensure their overall portfolio is properly integrated and positioned to take advantage of the evolving market conditions in each sector. This will ensure that the portfolio is capitalising on the best opportunities at any given time, and efficiently delivering the primary benefits of private credit: illiquidity premia; exposure to hard-to-access economic drivers; better recovery rates; robust covenants; security; and predictable cash flow.
The argument for a more integrated approach to investing across a range of related sectors is even stronger for private credit than it is for public credit.
The argument for a more integrated approach to investing across a range of related sectors is even stronger for private credit than it is for public credit. First, investing in private credit requires direct origination of new loans (rather than acquiring assets in the secondary market), and gaining exposure can be ‘lumpy’ as the investor needs to work with the opportunity set that is prevailing at the time. An integrated approach to investing across multiple sectors allows the investor to focus flexibly on those areas that are providing the most attractive relative value and loan flow at the time, and to pivot elsewhere as the environment changes.
The second reason pertains to tactical reallocations among sectors. In the public bond markets, a tactical reallocation among, for example, government bonds and corporate bonds could be easily executed thanks to relatively liquid secondary markets. However, as most areas of private credit have essentially no secondary market, shifts in tactical allocation entail thoughtful reinvestment of maturing assets as they are repaid in the sector that presents the best value, and this requires common oversight across the various sectors in a single portfolio.
There are good reasons some investors might choose to maintain a degree of separation between different areas of private credit. These include more closely controlling the asset allocation among sectors, more tightly defining the permissible investment attributes in each sector (which may be particularly important for certain insurance mandates), and the potential to select specialist investment managers in each sector. However, the internal resourcing and governance requirements for such an approach are typically only available to the largest investors. Those benefits that arise from a more disaggregated approach need to be weighed up against the many advantages that accrue to investing on an integrated and holistic basis.