‘Golden age of private credit’ comes with idiosyncratic risks: Pictet

Pictet Asset Management head of private debt Andreas Klein says “mainstream” private credit investments have probably run their course as buyout activity decreases and global regulators up their oversight of the booming asset class. Instead, investors should consider “micro-niches” such as the lower-mid-market, litigation and biosciences financing, he argues, but warns these emerging corners of the market come with hidden and unique risks attached.

Buyout volume as a percentage of S&P market capitalisation is at the lowest level ever recorded, Pictet Asset Management head of private debt Andreas Klein told the Fiduciary Investors Symposium.

The statistic suggests a dearth of demand for capital, which, coupled with “excess dry powder” from enthusiastic institutional investors, provides some evidence for the topical assertion that cracks are starting to appear in the veneer of the private credit boom, Klein said.

“There are definitely some headlines and … media coverage about the heat within the market and some of that is definitely justified,” he told the symposium hosted by Top1000Funds.com at the University of Toronto, Canada, last week. “You have this imbalance between supply and demand. And consequently, it’s obvious what happens, there’s a pressure on returns.”

Global private credit assets are estimated to have doubled in just a few years to surge past $2 trillion, according to the IMF, which has warned the market presents a potential “vulnerability” for the financial system.

Klein said the penetration of private credit as a capital source for borrowers continues to increase, due to myriad macro and geopolitical factors especially the retreat of banks from certain lending markets due to balance sheet mismanagement (think Silicon Valley Bank, First Republic and Credit Suisse) and higher regulatory standards, alongside lower public issuance.

But he outlined Pictet’s thesis that this “golden age of private credit” is “unlikely to stick around”, even though the high default cycle some had anticipated in the post-pandemic era never really eventuated, giving some false hope to the market.

Micro-niches over mainstream

“There’s certainly some elements of concern going on,” Klein said. “Now, do we still think that there’s value to be had in the private credit markets? I obviously wouldn’t be sitting here if we didn’t think so. It’s just you need to think about credit from a different perspective.

“The mainstream solutions have probably run [their] course. Yet, the vast, vast majority of assets going into the private credit space is into mainstream funds. So where can you still find value?”

He argued that the opportunity for pensions and sovereigns lies in “micro-niche” markets and strategies. “We like the lower-mid market, for example, we think it’s a much more insulated market,” he said. “We think the supply and demand dynamics within the lower-mid market are much more balanced. Structurally, there are more small corporates than there are large corporates and hence the borrower universe is much wider.

“In 2008-2009 it was deposit money that regulators were focused on – now it’s really pension money that regulators are focused on.” – Pictet Asset Management head of private debt, Andreas Klein

“Furthermore, the idiosyncratic risks that you find within a heterogenous market environment allows you to structure around that risk and drive incremental yield whilst protecting yourself against that. And we’ve seen that the lower mid market has been much much more resilient than the larger cap in terms of margin preservation.”

Other micro-niches singled out included litigation debt finance, biosciences finance and significant risk transfer, which usually involve the transfer of credit risks from banks to investors, often using synthetic securitisation.

“These are just areas that you can think of that are uncorrelated that have potentially diversification elements and bring resilience into the wider portfolio,” he said. “It comes down to manager capability for origination, particularly on proprietary origination, being able to find these assets that have these specific characteristics within micro-niches that are protected.”

‘Orange flags’ and ‘shadow banks’

Asked whether government regulation posed a threat to the market by potentially limiting the appetite of asset managers to take up the lending mantle forfeited by banks, Klein said more regulation was not only likely, but welcome.

“I think there’s a lot of underlying systemic risks within this ‘shadow banking’ market,” he said. He warned of a number of prevalent “orange flags” investors should look out for.

“There’s a lot of hidden leverage, whether that is at fund level [or] leverage within the underlying assets; [there is a] significant increase in the number of continuation vehicles for private equity vehicles [and an] emergence of ‘hold co.’ financing or NAV financing to provide liquidity to underlying LPs. These to me are all signs of orange flags that mask a larger underlying issue.