Why the private credit cycle has 2-3 more years to run

More investors are moving into private credit. Opportunities from the pandemic are far from over and the asset class is proving an important allocation in a wider, simplified fixed income portfolio. Investors at FIS Digital discuss their allocations and approaches.

Prevailing wisdom has it that the opportunities that characterised private credit in 2020 are fading with the recovery. Not so says credit solutions investment manager SVP Global with deep roots in distressed investing.

“We have never seen more opportunities. We are extraordinarily busy,” says Ranji Nagaswami who is chief strategy and chief commercial officer and co-head of the ESG committee at the firm.

SVP Global has made $9 billion of new investment in the last two years, $5 billion of which has been made in 2021 in an evolving opportunity that began with rescue financing and corporate restructuring and is now focused on private debt. Investments include restructuring a mall business and investing in aviation debt where the sources of recovery are linked to the underlying aircraft and a claim against the airline, Nagaswami told delegates at FIS 2021.

“We’ve got two to three years of this opportunity still to run,” she said.

Opportunities in the US outpace those in Europe, but investors should expect more opportunities in Europe through 2022. For example, the ECB estimates bad debt on European banks’ balance sheets could grow to trillions in 2022.

Correlation with equity and widespread leverage bring risk to private credit allocations.

“In a crisis, high yield and equity are correlated,” she warned. She also noted investors should understand the dangers of leverage both in the underlying investment, and another layer in the underlying fund. Although this “bumps up the yield,” she said the additional layer is worrying for investors particularly in a protracted crisis.

Leverage and correlations makes manager selection – and only working with managers who have experience through credit cyles – crucial, said fellow panellist Michael Hitchcock, executive director of South Carolina Retirement System.

“We look for mature programs to see how the manager has performed through different scenarios,” he said, warning investors that once they are in funds, they can’t get out since the premium comes from the illiquidity.

At peer fund Ohio School Employees Retirement System private credit accounts for a 5 per cent target allocation and generates a 7 per cent cash yield. The portfolio has generated nearly 9 per cent total return in the history of the private credit portfolio, set up seven years ago in an original opportunistic portfolio. Today strategy is focused on providing better terms to borrowing firms and using less leverage, said Farouki Majeed, chief investment officer at the fund.

In dislocation-orientated direct lending strategies, the pandemic provided opportunities to provide liquidity to cash-strapped companies in the small to mid market, he said. Ohio’s allocation is divided between structured credit, distressed and dislocation opportunities and the fund also co-invests in private credit with long standing partners.

Today Majeed is particularly concerned at the amount of money flowing into private credit as large funds like CalPERS seek to allocate more, raising their thresholds to the asset class.

Investors are increasingly allocating to private credit as the role of fixed income changes within portfolios. South Carolina used to have an overly complex portfolio with 18 different asset classes, explained Hitchcock.

Now the portfolio has been remodelled to five asset classes based on a philosophy of simplicity rather than an “always on complexity” so that any complexity must prove it offers risk reduction or additional returns. Private credit is focused (75 per cent) on direct lending and (25 per cent) on opportunistic allocations and tasked with providing a persistent source of income with downside protection. The wider fixed income allocation is tasked with providing diversification and liquidity.

Simplicity is also a watchword at Ohio where the portfolio is structured to have the minimum possible number of asset classes.

“What you can do with less there is no point trying to do with more,” said Majeed.

In one recent evolution, hedge funds have been dropped from the strategic asset allocation. The fund has migrated from hedge funds into real assets and private credit after the realisation that hedge fund returns had not been as strong in recent years. The allocation to real assets has risen to 17 per cent from 10 per cent.

Elsewhere, Ohio has worked with one of its tech-focused private equity managers to tap private credit. The asking price for a few companies was “too high” and not a viable equity investment, recalled Majeed. But by providing a structured capital solution, the asset owner and manager were able to create a new avenue for the firm.