While the rebound in private equity (PE) during the pandemic crisis has generated considerable attention, the accompanying acceleration in private credit markets has been more frequently overlooked.
In the face of persistently low yields on Treasuries, corporate bonds and other forms of traded public debt markets, investors worldwide have been turning away from traditional sources of income and looking for better returns elsewhere.
In fact, private debt has followed a similar upward trajectory to private equity. At the end of 2016, the private credit market was worth about US$575 billion, according to Preqin data. By the end of 2020, the market had grown to US$848 billion, and private debt is forecast to expand more than 11 percent a year to US$1.46 trillion by the end of 2025.1
According to a 2020 Private Credit Fund Intelligence survey, about two-thirds of intermediaries plan to increase their allocation to private credit in the second half of 2021, and Asia is a particularly fast-growing market.
“Over the past decade, private credit has developed into not only an accepted asset class, but also an increasing strategic allocation for investors who view the asset class as a flexible capital substitute for publicly traded fixed income,” said Chee Jiun Wen, Head of Private Markets & Alternatives at Bank of Singapore. “Private credit lenders have occupied the void left by the retreat of commercial banks and investors have found the asset class attractive given its return profile, floating rate protection against rising interest rates and low correlation to traditional risk assets.”
Traditional lending tightens
What’s driving this acceleration? The winding down of government stimulus and liquidity measures as the world looks toward a post-pandemic future has created a fertile environment for private debt. While central banks around the world stepped in to rescue struggling businesses during the crisis, in many cases the effect of these relief packages will be to disperse defaults over a longer timeframe, creating a long pipeline of distressed opportunities in the future.
“It could perhaps be too early to gauge the longer-term impacts of these measures,” Chee said. “However, it has generally served investors well to consider having managers in their portfolios who can lean into distressed opportunities as and when these arise. The belief is that good private credit managers in this space can continue to find idiosyncratic opportunities whether or not there is broad-based distress in the market.”
As stimulus winds down and cash-hungry businesses go in search of capital to fund post-pandemic expansion or recovery operations, they are increasingly likely to turn to private debt because of tightening conditions among traditional lenders. Regulatory requirements in the form of stricter capital adequacy ratios are forcing lenders to put more money aside, while low interest rates limit the profits they can generate from loans.
And since businesses everywhere still need capital, this has created a vacuum that private credit can help to fill. Many of those companies will be small or medium-sized businesses that might fall below a now-higher minimum loan threshold demanded by traditional banks.
The boom in PE has also had the ancillary benefit of stimulating private loans, which offer faster and less cumbersome deal-making potential, eliminating the need for drawn-out negotiations with underwriters, ratings agencies and regulators and the need to deal with uncertainty of public roadshows and market sentiments.
The result is that investors looking for more yield, diversification and flexibility now have a much more diverse range of products on offer, from more plain vanilla direct lending, bespoke mezzanine financing to distressed credit investments and other alternative sources of yield.
“Even just looking at the less complex direct lending strategies, there is accretive value for investors’ portfolios. Historically, these offer higher yield than those found in public markets,” Fidelis Oruche, Head of Investment Advisory & Sales at Bank of Singapore says. “They also offer greater protection from rising interest rates, as these loans have shorter duration (hence less sensitivity to interest rate changes) and are typically floating-rate loans with contracted floors. Such loans may also include call protection and pre-payment penalties.”
Risk and reward
The appeal for investors is clear. Firstly, the yields on private credit investments are typically higher than those offered by corporate bonds. Private lenders are often able to negotiate greater control over loan terms, meaning they are better protected from risk, and because they tend to feature small pools of lenders rather than large syndications, the chances of recuperating capital in the event of default are higher.
This appeal is being magnified by a general heightening of risk appetite. In the current low-interest-rate environment, many investors are accepting more risk to gain returns, including the traditional illiquidity associated with private debt.
However, as with PE investment, investors face the challenge of accessing this complex landscape, and finding the global reach necessary to capitalise on these opportunities. Private credit also demands a particular expertise; managers who are able to assess companies and command strong balance of power in often-bespoke loan negotiations.
“Private credit has structural features which can provide an attractive risk-return profile,” Oruche said. “For instance, private loans tend to be relatively senior in the capital structure, often secured by property, plant or equipment, with meaningful covenants.
“Investors remain hungry for sources of extra yield – but they also need to avoid stretching too far and taking on more risk than they bargained for to capture that yield”
Breadth of expertise
Bank of Singapore has access to the breadth of expertise required to navigate this market.
The bank collaborates with best-in-class managers to access a range of private credit opportunities, including the creation of a customised barbell approach to performing and stressed credits with a leading value credit investment firm, funds focused on privately originated senior secured loans to established, sponsor-backed companies. Bank of Singapore also looks beyond fixed-income sources, seeking alternative uncorrelated sources of yield through strategies such as General Partner stakes investments and income-producing private infrastructure.
“While private credit continues to appeal to a broad spectrum of investors, the illiquid nature of such investments can prove too high a barrier to entry for many investors,” said Chee. “As such, Bank of Singapore is helping our clients search for hybrid credit strategies which offer similar structural benefits of private credit and yet periodic liquidity for investors.
“Ultimately, we believe well-managed, diversified portfolios of private credit can provide robust and resilient returns to investors with long-term investment horizons.”
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