Private Credit Spectrum of Solutions
Prudent Execution Takes Center Stage
With the burgeoning capital flows into private credit in recent years, a question that’s on the minds of more institutional investors today is whether asset managers have the ability to access or directly originate deals that will be appropriate to their investment objectives. The answer: There’s no one-size-fits-all.
Goldman Sachs Asset Management pursues a direct origination model which, Olafson emphasized, is critical to success. “The directly originated model is take-and-hold,” he said. “You are better able to assess risk because you get that direct diligence access as the lender. That really is a critical piece.” While identifying attractive opportunities in private credit is not difficult, accessing them can be. “Everybody can see that it provides good deals, but you have to get behind the velvet rope, so to speak. And we have very deep, very long-standing and very comprehensive relationships.”
Origination capability is a key factor that Fama at Cambridge Associates considers when assessing managers for clients. “In opportunistic strategies, we’re looking for people that can originate unique investments, because they can structure deals the way that they want and earn a better return,” he said. “They need to be nimble and originate interesting opportunities. That becomes more important in this sector.”
For some private credit sub-asset classes, due diligence includes not only the primary manager, but also secondary managers — each of whom may have a different investment style. “For direct lending, we like a large manager that has been around a long time and has experience with credit cycles. We like teams both with the experience and the resources,” he said, versus the more opportunistic strategies, where direct mto unique investments is more important.
Proper Transparency
Investors are keen to work with private credit managers who have strong investor-relations expertise and a high level of transparency. “The client and the manager should have a close, enduring and transparent relationship,” said Olafson. “It is imperative upon the manager, who is the fiduciary, to communicate, to be transparent and to share performance and market views with the capital providers.” In fact, as the private markets have grown, managers have had improve their efficiencies in delivering critical information to limited partners. “I would stress that capital providers should expect transparency, engagement and an understanding of their risk exposures from their manager,” he said, which needs appropriate technology and systems to do so efficiently.
And since each investor has a different risk perspective and tolerance, customization is key. “The metrics that you will need to focus on — apart from just performance, beating the benchmark and risk-adjusted returns — differs by client,” said Olafson. “It’s all those things, but ultimately, you’re talking about the specifics of that client’s needs and how you can help.”
Eye on Potential Returns
As investors monitor economic risks to private credit as an asset class, given that infl ation remains elevated in some industries with the potential for slowing growth, they should keep an eye on default rates.
“We’re seeing pockets of stress in different sectors,particularly what have been thought of as more stable sectors like healthcare, because of wage inflation and other issues where they can’t increase their revenue, and software, which may not have met expected growth targets,” Fama said. While these sectors are not showing defaults, there is some under-performance that requires attention. Overall default rates for private credit are in the 2% range, he said, which is typical in a relatively calm economic environment.
In fund finance as well, default rates are historically low, which is partly due to the nature of the investment. “In subscription-line lending, you’re taking credit risk against committed LP capital within a vehicle. You’re not taking credit risk against assets,” said abrdn’s Morrison. “That’s one of the reasons that we aren’t seeing an uptick in stress or a pickup in default rates.” But she expects to see greater dispersion in manager performance, particularly as the macroeconomic environment changes. “It will highlight managers that have been very disciplined with their underwriting and structuring, and that have had a collaborative relationship with the borrowers,” she said.
Positive Turn
Even if the Fed’s next move to lower interest rates will take some time to fl ow through the economy, it would ease the pressure on borrowers — further driving investor interest in private credit as companies seek to refinance.
“Without question, when rates come down, transaction volumes will pick up,” Olafson said. As investors anticipate a new economic and credit cycle, it can help power the private credit markets. Investors will “look through to lower all-in-all base rates, and they’ll be willing to transact, which ultimately is what needs to happen to allow buyers and sellers to clear.”
“If the Fed is lowering rates to relieve the expensive cost to borrow as opposed to addressing weakness in the economy, which might cause a more rapid decline, then I think there may be a scenario with continued stability and attractive yields” in private credit, Fama he said. “Rates would be somewhat lower than they are now but still would be elevated relative to where they were for the last decade.”
The industry’s shift away from a product orientation to a solutions mindset has led to greater collaboration between manager and investor. That’s important as the economic backdrop — and institutional investors’ goals — change more quickly than ever. “The dialogue has shifted a great deal,” Olafson said. “It’s not about, ‘We have this fund.’ It’s more, ‘We are partners. What are your objectives? What are your big challenges?’”
Whatever the future holds, businesses will continue to need to finance growth, and they will turn to private credit for the most attractive financing they can access— with institutional allocators not far behind.
