Private Credit Opportunities within a Holistic Alternatives Portfolio

Private market investments, a key component of an alternatives portfolio, can provide opportunities to generate non-correlated returns within portfolios and enhance overall portfolio risk/return, while still providing for meaningful upside. At Defiant Capital Group we believe alternative asset portfolios should be built holistically like any other asset class (e.g. equities), with one of the key building blocks the use of Private Debt and and investments in private credit.

When we look to deploy assets into private markets we weigh the risk/reward associated with the structure of the vehicle (non-regulated private investment), illiquidity, the potential for loss, and the potential for upside. Given trends in alternative investments and the current environment our recent focus has been on two segments within alternatives – private credit and venture capital.

In this post we examine the current opportunity set for private credit markets, why we think they continue to present a compelling investment opportunity for investors, and some of the investor factors to consider when allocating them into a portfolio.

1. Private debt strategies tend to have shorter fund lives (i.e. capital lock-ups) than other private market assets

Shorter fund lives lower the required illiquidity premium for investors, as well as provide the opportunity for investors to redeploy capital faster. In addition, the potential return drag from poor investments is minimized (compared to other private market investments) given the shorter fund lives and regular distributions. And with most funds drawing only 75% – 80% of commitments (assuming a 20% – 25% recycling of early investment returns), the illiquidity timeframe and cash drag is further reduced.

2. Inefficient segments of private credit markets (e.g. lower middle market) benefit from wide spreads, high cash yields, and can have equity-like return potential

From a return perspective, levered senior debt and opportunistic credit (e.g. growth based debt) can produce returns that are in-line / above public market comparisons (both on the equity and fixed income side), and also approach those of some private equity strategies. The need for non-dilutive growth based debt results in many private companies willing to pay higher coupons and transactional costs in exchange for transactional efficiencies (i.e. speed to close) with more aligned debt partners vs. traditional banks.

When compared against traditional fixed income investments private credit has historically experienced higher returns with less volatility and downside risk. And with many private debt investments incorporating equity warrants skilled managers have the ability to generate upside in-line with Private Equity, but at a significantly lower risk profile given the higher placement in the capital stack and asset-backed debt.

3. Loss rates on private credit have historically been below those of speculative grade bonds, and more in-line with investment grade bonds

Strong underwriting and highly engaged investment teams have resulted in private middle market loans having attractive loss rates that are below those of speculative grade bonds. In addition strict covenants, asset-backing, personal guarantees, and tight monitoring of loans and business operations by lenders helps limit downside loss potential in the event of a business downturn.

4. Private Credit presents a compelling opportunity for yield hungry investors, with regular distributions also helping to minimize illiquidity drag

Private debt strategies are designed to produce regular income, appealing to investors that are searching for yield in the current environment. With most Private Credit funds having shortened investment periods compared to other private market investments (two years on average for private credit vs. five years for private equity), recycling of payoffs and coupons is less common resulting in more distributions to investors sooner. Furthermore, regular distributions from coupons, origination/exit fees, and prepayment penalties enhance distributions and compensate investors for their illiquidity.

5. Private credit and debt sectors tend to have a low correlation with public markets, creating opportunities for portfolio diversification

Given low correlations with public markets the inclusion of private credit and debt investments inside a portfolio can enhance overall portfolio construction and potentially reduce risk. Lagged mark-to-market of debt investments helps to smooth out intra-quarter/month volatility, while strong underwriting and hands-on investment teams work with private business owners as partners, helping maintain the overall credit quality of investments.

Opportunities today in Private Credit

Amid government stimulus, monetary policy, and low rates, it is a difficult environment for investors to seek differentiated returns. While government support (both fiscal and monetary) has helped drive the epic bull market post-2008, it has come at the cost of differentiation. Within portfolios today public equity markets are exhibiting staggering returns, especially in the US, but the ability to diversify the sources of risk/return are at all-time lows.

At the same time fixed income investments, which typically have provided diversification of risk from equity markets, face return headwinds from the low rate environment, the looming removal of easy monetary policy, and the potential for rate hikes. And on the risk-side, a consequence of Fed support for equity / fixed income markets has been highly correlated cross-asset returns.

Private debt investing offers opportunities to create value within an investors portfolio. With attractive loss rates, engaged lenders, regular distributions, and the potential for enhanced return through equity warrants, they present a compelling investment option.

Like any other private market investment underwriting, due diligence and proper analysis of risk is important. For investors that are qualified and able to withstand the illiquidity Private Credit provides a unique way to enhance yield, total return, and portfolio divarication. We encourage investors to to discuss the topic with their advisors to see if Private credit makes sense for them in their own portfolios.