After the 2008 global financial crisis (GFC), where banks retrenched from lending to small-middle market opportunities, private credit managers stepped in to fill the void, leading to the extraordinary growth of the asset class. As the data below illustrates, private credit (debt) grew dramatically from 2009 through 2022, with diversified growth across direct lending, mezzanine and distressed.
Private credit has been a growing allocation for institutions and family offices due to its attractive risk-adjusted returns, high income potential and inflation hedging.1 And, recently through product innovation, private credit is now available to a broader group of investors, at lower minimums, and with more flexible features. It is estimated that most private credit is floating rate, and the asset class delivered positive returns in 2022, as the coupon rate adjusted as rates rose throughout the year.2
We see parallels to the post-GFC market environment, where private credit managers stepped in to fill the void traditional banks had left. In a post-Silicon Valley Bank market environment, private credit managers will have the upper hand in negotiating favorable pricing, terms and covenants. During the last several years, with growing competition for deal flow, there was an increasing amount of “covenant-lite” deals. Now, private credit managers have the leverage to negotiate favorable terms and covenants.
Looking ahead, we anticipate seeing a larger dispersion of return between experienced managers who can navigate the challenging environment, and those whose only experience is investing capital during an easy money environment, with low default rates. Even if default rates rise, we believe seasoned managers, with experienced workout teams, should be able to renegotiate terms.
In today’s market environment, private credit managers can be more selective in deploying capital. Like the post-GFC environment, the pendulum has switched to favor lenders in these tight credit conditions. Experienced private credit managers should be able to effectively navigate these challenging conditions in an effort to generate favorable outcomes.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.
Investing in private companies involves a number of significant risks, including that they: may have limited financial resources and may be unable to meet their obligations under their debt securities, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of realizing any guarantees that may have obtained in connection with the investment; have shorter operating histories, narrower product lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors’ actions and changing market conditions, as well as general economic downturns; are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on the portfolio company and, in turn, on the investment; generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position.
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1. Sources: CAIA Association and Preqin. 2022 UBS Global Family Office Report. Prepared by FT Capital Markets Insights Group. Private Credit represented by Cliffwater Direct Lending index as of September 30,2022, back filled with Credit Suisse Leveraged Loan Index prior to January 2005.
2. Source: Pitchbook Private Debt Report, 2022.