Winds of change blowing through private credit markets

The influx of capital and interest into the private credit market has spawned new managers and offerings, but asset owners are increasingly alert to the fact that not every one of them is built equal, and even tiny losses during the credit cycle can eat significantly into long-term returns.

During a panel at the Fiduciary Investors Symposium at Stanford University, HOOPP senior managing director of structured and private credit Jennifer Shum warned of the danger of “compound losses”.

“There’s a lot of managers out there that haven’t been through a full cycle. We have,” Shum said.

“The losses are going to be interesting, because right now, every single private [credit] manager that you talk to says, I don’t have any losses – it’s 0.5 or 0.8 basis points. Everyone has the same deck.

“If a manager has tiny little nicks over time during the credit cycle, those compound losses are going to get you.”

HOOPP has been investing in private credit for more than a decade and Shum said the most attractive aspect of the asset class is the current income. The presence of covenants also protects lenders and brings the board to the table when things don’t go according to plan.

“We are the debt investor, [so] we’re going to be able to have a conversation with the borrowers on the private equity side, so there’s really interesting downside protections on private credit versus private equity,” Shum said.

Illinois Municipal Retirement Fund (IMRF) chief investment officer Angela Miller-May said the $52 billion fund is similarly bullish on the asset class and has painstakingly gone through a manager selection process for that part of the portfolio.

It completed an asset liability study in 2022 and established a three-year implementation plan to reach a 4 per cent allocation to direct lending, asset backed lending, and opportunistic private credit, funded by reducing equities, Miller-May said.

“We evaluated various strategies across the credit spectrum to really look at managers that could complement each other, could diversify the portfolio, and have unique strategies with a competitive edge,” she said.

“We put out an RFP in April of 2023 we got over 200 applicants…we came down to 13 managers.”

Miller-May said the fund is expecting its position to change over the credit cycle, hence the number of managers it hired as the base of the portfolio. Now, the fund sees appealing income generation and risk-adjusted return prospects, and the role of private lenders as providing capital where it is scarce.

“Plus the exit environment that we’re experiencing in private equity, where private equity companies are seeking financing solutions as well to infuse capital or provide distributions to liquidity constrained investors,” she said.

“We think that increases the opportunity set for private credit.”

Looking ahead, though, HOOPP’s Shum said private credit has somewhat become “a victim of our own success” as with the capital injection, investors are seeing some “lighter covenants”.

David Geenberg, managing director and head of North American investment team at opportunistic credit manager Strategic Value Partners, said the winds of change are already blowing in the leveraged credit markets.

“We are already seeing an increased restructuring cycle,” he said.

“It started about a year and a half ago. You can see significantly elevated restructuring rates, where it is visible in syndicated leveraged markets and leveraged loans, and high yield.”

Depending on which data points investors are looking at, defaults rates for the LSTA US Leveraged Loan Index is between 4 and 6 per cent, Geenberg said. It was within that range last year, and SVP is expecting that to be the case next year.

“You’re going to see over three years, 10 to 12 per cent cumulative restructuring in these portfolios,” he said.

“In the US and Europe – just in corporates, private equity, leveraged loans, direct lending – there are ten trillion dollars. So we think you’re looking at a trillion dollars’ worth of assets that get touched however they’re touched by the cycle.

“We think that it has both been a profound opportunity for investors like ourselves, but it is also a profound risk. We’re not telling you it’s going to cause a giant economic cycle, but it is going to affect portfolios.”