Private credit explained: The risks and opportunities for investors

0:00Simoney Kyriakou: Welcome to the latest FT Advisor Margin Notes episode with me, Simoney Kyriakou, editor of FT Advisor. We have been talking about risks and opportunities over the past year, and in this episode we will be examining the risks, both perceived and real, that investors might face when it comes to private credit investment. We will also be considering the benefits that adding private credit into clients' investment strategies can bring to our portfolio. With me in the studio is Aaron Hussain, Global Market Strategist for JPMorgan Asset Management. Welcome, Aaron. Thanks for having me. Well, let's get straight into it, if we can.

0:37Simoney Kyriakou: Tell us, what is private credit investment in a nutshell? In a nutshell, private credit is essentially lending that happens between a borrower and a lender outside of traditional public markets, hence the word private. and private credit is often used interchangeably with direct lending, though the two are not the same. Private credit is a broad umbrella term with which direct lending is a sub-segment. The reason we often use those two words interchangeably is because direct lending is the largest sub-segment within the private credit universe. So today AUM globally in that segment is about$1 trillion.

1:17The broader private credit market is around$2.5 trillion. So it's a large part of the private credit market, but it isn't the entire private credit market. And it's grown very, very rapidly over the last 10 to 15 years. The reasons for that are relatively well understood today. But in essence, post-GFC, regulations made it much less profitable for the traditional banking sector to lend to small and medium-sized companies. So private credit funds, direct lending funds stepped in to bridge that gap. And that's essentially why we've seen such large growth in that particular part of the market. So put simply, direct lending is lending directly to small and medium-sized companies.

2:02And I think it's really important just to make that point because the middle market is very, very large. In the US, that's around 200 ,000 companies. In Europe, the number's quite similar. So there's a large number of small and medium-sized companies that need financing and typically haven't been able to access that financing through the banking sector or through public markets because they're too small.

2:27Simoney Kyriakou: Sure. And now this is the opportunity for investors then to be able to get some good income by investing in private credit. But UK investors, I think generally the retail market has been quite slow to take this up. I know institutional investors have been a lot quicker to invest in it and to add it into portfolios. Do you think that the retail market is finally catching up? Do you think there's still a sort of a knowledge gap? I think, as you rightly say, that historically, most of the capital that I just mentioned, the 2.7 trillion. Most of that is institutional capital in closed-ended drawdown funds, so limited life.

3:08The fund has a life of typically 10 years, and then it's closed. Managers raise new capital in new funds. Recently, some of the growth has been in the retail part of the market. Again, most of that growth has been in the US, what's typically called BDCs, business development companies, and they're listed and they have unlisted. They've driven a large part of the growth that we've seen over the last couple of years. But today, retail is about 15 % of the total market. Of course, we've seen regulatory changes in the UK, in Europe and in the US, which allow broader participation in alternatives of which direct lendings are part.

3:45So that's the reason we're seeing this growth in the retail part of the market. Because we now have structures or investment wrappers that traditionally retail investors couldn't access, they now can access.

3:57Simoney Kyriakou: Yeah, absolutely. And I think I know pension funds particularly have been quite interested in this because they need to meet liabilities and sort of long-term income can actually be really good for them. But then I've heard also from retail investors and people looking after retail investment money that there could still be risks associated for the retail market. So can we talk about some of these risks, both the real ones and the perceived ones and what that might entail? Yeah, sure. Maybe if we just take a step back and give more of an overview of what direct lending is and how it differs from public markets.

4:29I think the first thing that it's important to mention is direct lending and private credit shouldn't be used interchangeably. Direct lending is lending to small and medium-sized companies. I think the second is how does direct lending or loans differ from public markets? And typically the loans are floating rate instruments. So you're lending to a company and the loan is structured as the base rate plus a spread. So you can think about that as UK bank rate or Euroball in Europe or SOFA, which is the overnight lending rate in the US, plus a spread. So the loans are floating rate. They move as base rates move, which is clearly very different from public markets where the coupon is fixed.

5:11Simoney Kyriakou: And that spread is there to provide a bit of a cushion anyway, isn't it? That's right. So you can think about that as the compensation for taking risk in indirect lending. And today, those spreads are around 500 basis points over the policy rate, if you like. So yields are in the ballpark of around 9%. And as you mentioned, that's particularly attractive if you look at parts of public markets where yields are lower or the leveraged loan market where yields are lower. The other important point to mention, though, is, of course, because this is loans directly to borrowers in semi-liquid structures, these are far less liquid than public markets.

5:49And I think that's a really important point to get across. Even in a semi-liquid structure, that liquidity is periodic. It's not daily. And that's one of the other differences from public markets where there's a very active secondary market.

6:03Simoney Kyriakou: And that's why it makes it very attractive to institutions because they can sort of predict or as accurately as they can, they predict their liabilities over 5, 10, 15, 20 years. And so that longer term sort of semi-liquid structure can sort of suit that liability matching for pension funds or for long term funds. But for retail investors that perhaps might have a shorter term horizon, they need to be really mindful of that, don't they? Yeah, that's absolutely right. I mean, even if you're offering direct lending in a semi-liquid structure, it's far less liquid than if you're investing in something which is traded daily or traded monthly.

6:39So I think that's really important. But as you say, the benefit of it being illiquid has historically meant you earn a premium over public markets. And that's why institutional investors have been particularly attracted to this part of the market because they have long term investment horizons. And therefore, they're quite comfortable locking their capital up for a longer period of time.

6:59Simoney Kyriakou: And if I were an investor and I put my money into this and say some of the companies that have been lent to, they're looking a bit shaky, might not last. Generally, if I were a bond investor, I would expect to be paid first and then the equity investors can just take up any leavings that are left over if there are any. Where do I sit in that sort of scale of priority as a sort of direct lending investor? Yeah, I mean, maybe that's one of the other things I should have mentioned when I was talking about the differences between public markets or investment grade bonds or high yield bonds is that loans are typically senior secured.

7:37So they sit above the more junior parts of the capital structure where investment grade or high yield bonds sit. So historically, recovery rates have been higher in the event of a default because these loans sit senior to that part of the debt stack.

7:53Simoney Kyriakou: In terms of default rates, are they roughly equivalent to the public market ones or are they actually less problematic? Yeah, it's a great question. And there is no universal default rate in direct lending. It's one of the big discussion points in this part of the market. But if you look at the evolution of default rates over the last couple of years, we haven't seen a huge divergence between leveraged loans, which is the broadly syndicated loan market. It's still issuing loans, but it's a hybrid between public and private because it's syndicated by underwritten by investment banks and then sold to typically CLOs.

8:34And then you have the high yield bond market and default rates have basically moved in the same direction. There's some question about what the default rate is in direct lending today. if you focus only on payment defaults it's low it's about two percent if you add in what the industry likes to call selective default so broader measures of stress going to your lender and saying i don't want to pay cash interest this quarter i'd like to add it to the principal balance and pay you more in the future or going to your lender and saying can i extend the maturity by one year or we have a covenant in place which is just a restriction on the borrower to indicate early signs of stress, can we waver this quarter?

9:18So all of those broader measures of distress, if you add those to the default rate, which is what some data providers do, the default rate is higher. It's anywhere between 4 % and 6%. But I don't think they're a great measure of expected credit loss because you may be in a period of stress. You may have a short-term liquidity problem as a borrower, but not all of those that opt to use some of these more flexible arrangements end up defaulting. So it overstates the economic risk, if you like, relative to a payment default or a bankruptcy proceeding.

9:52Simoney Kyriakou: Sure. And in those situations, which as you say, are quite rare, would you then sort of renegotiate the yields that might actually end up being a little bit higher? That's right. One of the reason that you have the flexibility from the lender is that they tend to get paid for giving you this optionality. So if you use what we call a pick toggle, which is asking to pay more interest in the future rather than paying it today, there's a penalty that you would pay. So if the lender thinks that ultimately you will pay back principal in the future, it's beneficial for them to allow you to use some of these flexible tools on the loan.

10:27Simoney Kyriakou: Yeah. And that sort of pick toggle, you're talking about payment in kind, aren't you? That's correct. And that's one of the things I think advisors, you know, they might get asked about by their clients, like what happens if, and then the advisors say, well, you know, there might be a payment in kind. How does that then affect the client's sort of end return or anticipated return? Could you talk a little bit about PIC and how it works? Yeah. So PIC is referring to what we call paying in kind or payment in kind. And there are two types of PIC on a loan. There is PIC, which is included at origination.

11:00So you have the flexibility to use PIC. and that's deemed by the industry as quite positive because if you're a small company which you typically are if you're borrowing in the direct lending market and you don't have to pay interest you can plow that cash back into operations and hopefully grow your earnings faster in the future so having that optionality is tended to be viewed as relatively positive and then what we have what we refer to as amended pick which is you go to your borrower you go to your lender, excuse me, during a period of stress and say, I didn't have pick at origination, but I would like to use pick now.

11:35That's clearly a measure of stress. And as I said, we have seen that measure pick up. It picked up post 2022 when interest rates rose, but it's been moderating since. But what we ultimately care about in credit investing, whether that's public or private, is expected credit loss. And we're trying to infer what the expected credit loss would be using some of these measures. So put simply, if you had a spread of 500 basis points or five percentage points, and you assume defaults were going to be 5 % and you didn't recover anything, you would lose the entire five percentage points. If you expect to recover half in the event of default, the expected credit loss would be 2.5%, so half of the spread.

12:25So you're trying to infer if you're being adequately compensated for taking risk based on what you think the expected loss would be. And that's why we track these measures.

12:36Simoney Kyriakou: And does that make valuing companies slightly more difficult? And does it make valuing the quality of what you're investing in, the private credit, the loan, does that make it more difficult? In some senses, yes. I mean, direct lending is less transparent than public markets, but it is more transparent than people give it credit for. I mean, there's a view that loans don't adjust very quickly to changes in the environment. I don't think that's true. There are two very large valuation companies that value a large number of private credit loans every quarter. And you can see that these loans are being adjusted to the changing environment.

13:20So to come on to the question, how are these loans valued? Clearly, we don't have a very active secondary market to find a price, but we do have comparables. We do have valuers that value these private market companies and therefore are looking at the credit quality of these borrowers. And you do see plenty of instances where these loans are being discounted relative to par because the environment's changed or the discount rate has risen. And to maybe give you some context on that, there's about 8 % of the universe today, which is priced at more than 10 % discounts to par. So these loans do get marked.

13:59Their valuations do change, but they're being changed based on fair value accounting standards and trying to estimate fair value using discounted cash flow. Sure.

14:08Simoney Kyriakou: And then what are my options as an investor if I think, hang on, I don't think I'm being compensated enough now for the actual risks that are being taken, or I just don't think this is looking that attractive relative to stock markets or even to government bonds now with the ever increasing interest rates. Is there much flexibility for investors? Well, the investor has the choice whether to invest in a direct lending fund versus a public market fund. For example, if you have a suite of products available to you, you look at the expected return on the direct lending fund versus high yield bonds or the leveraged loan market.

14:47And you're making a decision whether you think the return is attractive given the relative risks between the two markets. And one of the benefits, I suppose, of direct lending versus high yield is when interest rates rise, the yields on direct lending loans rise because they're floating rate. So one of the paradoxically, one of the benefits to the direct lending market was post 2022. We saw all in yields rise from around 8 % before 2022 to a peak of about 12 % in 2023. And that's because base rates rose. So the all-in yield was more attractive, but the spread has narrowed. So you're getting a higher all-in yield, but the compensation for additional risk is slightly narrower than it was a few years ago.

15:35Simoney Kyriakou: Yeah, of course. And this then makes the case for having a diversified portfolio rather than just trying to do it yourself. You know, it's best to have a diversified portfolio with lots of different loans within it, because then you're sort of mitigating the risk and diversifying and spreading the risk across it, right? Yeah, that's right. And I mean, we should say at the outset that you are typically going to be more concentrated in a direct lending fund than you would be in an equivalent high yield. So you're going to typically have less loans in the portfolio. One way to mitigate that is to invest across direct lending funds or to invest in a manager that has a fund-to-fund structure where they're diversifying across managers, diversifying across vintages, across geographies to try and build diversification across the direct lending book.

16:21Simoney Kyriakou: So how do redemption terms align with sort of liquidation strategies? How do managers perhaps achieve that diversification to help mitigate risks and maturities? Yeah, it's a great question. And of course, when we're looking at the retail part of the market or semi-liquid fund structures, as I said, they typically offer periodic liquidity. and that's typically 5 % of NAV a quarter. And you often get asked the question, as you rightly ask, how does that fare with the maturity of the loans in the portfolio of the direct lending fund? And typically, loans have a maturity of between five and seven years.

17:00And if you take five years as an example and you had staggered maturities, so not all of them were maturing at the end of year five, you had an equal rollover in every year, you would be generating about 20 % annually, which is about 5 % a quarter. So the 5 % of NAV matches the underlying maturity profile of the loans. Of course, if some of those loans have maturities that are extended, that will bring down the annual turnover. But what you typically see is they have a five or seven year maturity, but they're refinanced in years two or three. So actually the annual turnover is typically much higher.

17:40And that's the reason that these funds can meet their redemptions with the turnover of the loans maturing, or at least that's what's supposed to happen in practice.

17:51Simoney Kyriakou: And that sounds like it helps when you're trying to do a long-term income strategy for a client because you almost know sort of what's going to come in year after year and you can create this wonderfully diversified income portfolio, can't you? That's right. And I think that's why direct lending still has a role to play in a diversified portfolio within a diversified credit sleeve. It is less liquid. So if you're looking for liquidity, I don't think that's where you should be trying to source your liquidity. I do think that this should be viewed as a longer term investment that complements the other part of the portfolio.

18:25But in moving into the less liquid part of the market, historically, you have been rewarded with additional return. Today, yields are still higher than they are in public markets. So they're about one percentage point higher than leveraged loans. And there are close to 200 basis points over high yield today. And of course, that's because you're moving into a riskier part of the market. You're taking a slightly more concentrated position. And historically, you've been rewarded for doing so. Yeah.

18:55Simoney Kyriakou: Well, as we know, the FCA is very keen to move us into risk assets. We've got, I think,£430 billion sitting in cash accounts across the UK. I think for the first time, the UK has outstripped Germany in terms of how many people are actually investing in cash, which is quite worrying. Do you see that perhaps as being promoted a bit more, or do you think that perhaps advisors can have greater conversations now with clients about these sort of strategies to maybe get some of that, to put some of that income to work? Yeah, I mean, if we look back historically, it's never been a great idea to sit in cash.

19:30I understand that people tend to move into more liquid or into cash when they're worried about the investment markets. But historically, sitting in cash hasn't been a good idea. So getting people invested is a good idea. And as I say, I think direct lending has a role to play. I know pension funds are keen to get more of the capital into what they call productive assets, whether that's infrastructure, whether that's private equity, and some of that goes to private credit, to fund fast -growing, innovative businesses that are private in the UK. So I think that's a good initiative on the understanding that you understand these are illiquid investments.

20:11So I think it makes a lot of sense, particularly in defined contribution, for example, where if you're in the accumulation phase, you don't need liquidity and therefore you sort of match with the profile of growth over time.

20:24Simoney Kyriakou: So what about inflation protection? Can you talk a little bit about that element? Yeah, I mean, I've been out on the road a lot talking about the importance of having asset classes in the portfolio that can protect us from inflation. Of course, for a long time, we were in an environment where nobody was worried about inflation, where we had inflation that was too low, we had interest rates that were too low. And of course, 2022 changed all that. And it's very likely that if we look to the next decade, we're going to be in an environment where inflation is more of a problem. 3 % is probably going to be the new 2%.

20:58Simoney Kyriakou: Exactly. So what I refer to as creeping inflation, where, as you say, you think it's going to be 2%, it ends up being 2.5 % or 3%. Do I think direct lending is the best asset class to protect you from inflation? No. I think there are other private assets which do a better job, particularly of protecting you from creeping inflation, things that have incomes that grow over time. So real estate, parts of the real estate market where supply is constrained and you expect maybe stronger rental growth that protects you from the creeping effect of corrosive inflation. Then you have infrastructure, which tends to have revenues or cash flows that grow in line with inflation, too.

21:40But paradoxically, direct lending was one of the best performing asset classes in 2022 and the years following because we experienced an inflation shock.

21:50Simoney Kyriakou: Yes, of course. Yeah. that was followed by a sharp increase in interest rates. And because direct lending loans are floating rate, they adjusted higher. So paradoxically, returns were higher in the years where we had the higher inflation. So I think in certain environments where you have an inflation shock followed by higher interest rates and growth remains resilient, you get the benefits of higher rates as a lender. And it's not putting too much pressure on the borrower because it's a bit of a double-edged sword, the higher rates go, the more difficult it is for the borrower to service their debt.

22:25Simoney Kyriakou: Sure. And we are looking at sort of, we are currently in a high rate environment, but we're also hearing hawkish sounds from the Fed and from actually a lot of Western central banks, sort of pricing in rate cuts. Is that going to be detrimental to the direct lending market? Yeah. I mean, depending on your view of where interest rates go, it can ultimately be a positive or a negative because direct lending loans rise and fall with interest rates if you expect that we're going to see lots of cuts from the major central banks direct lending loan yields will come down and therefore that's clearly a negative though the other side of that is it eases the pressure on the borrower yeah so you should expect the default rate to come down too.

23:10So the net effect is actually ambiguous. You're just trying to work out which is more important to your return profile. Is it having a higher yield or is it having a lower default rate? Of course, the higher yields go, the more pressure it puts on the borrower. The lower they go, the less pressure it puts on the borrower. And there clearly has been a sweet spot where we've seen these returns which were higher than they were prior to 2022. And we haven't seen material stress coming through in elevated payment defaults, though we did see a pickup in broader measures of stress.

23:44Simoney Kyriakou: But then, as you say, it all depends. It depends on the client, the client profile, the portfolio. There are so many different things that, you know, if you do want to have interest rate protection or inflation protection, there are other elements you can put into a portfolio to diversify, to mitigate the risk. But it sounds like we've actually busted some of the myths around private credit and direct lending. So thank you very much, Aaron, for taking the time to talk to us. Thanks very much for having me. Thank you. And thank you for listening. Until next time, take care.

24:34Simoney Kyriakou: house workflows, inventory, returns, and analytics in one place. What used to take five separate tools ShipStation does in one. Automate fulfillment and rate shopping to ship up to 15 times more with up to 90 % savings. Go to ShipStation.com and use code AUDIO to try ShipStation free for 60 days. Cash Now More Later from Opendoor gives you cash up front for your home, plus all the profit later. That's no chaos now, no cash left behind later. Skip the showings now. Pocket extra profit later. This is so simple now. This is so awesome later. Or sell fast now and pop the champagne later. Cash now more later.

25:15Simoney Kyriakou: Now available nationwide. Start your offer at opendoor.com slash ACAST. Profits calculated after fees and costs, eligibility and offer price may vary.