In an environment where it is becoming increasingly difficult for businesses to obtain debt from banks, financial advisors are looking to allocate more funds to private credit investment vehicles.
A survey of 260 financial advisors last fall by Mercer Investments and CAIS found that 98% of respondents were already invested in private debt. Nearly half (45%) allocate 6% to 20% of client portfolios to this asset class. 68% of respondents plan to increase their allocation to private credit in the next 12 months. Another 23% plan to maintain their current allocations.
Gregg Sommer, partner and head of U.S. financial intermediaries at Mercer Investments, noted that while private equity remains the top choice for advisors when it comes to growing clients’ allocations to alternative investments, private credit has almost caught up.
“Private credit continues to gain momentum,” he said. “It’s clearly an income-producing asset class and when we think about wealth management, some potential clients need income. The income aspect will continue to be emphasized and will likely become even more important in the future.”
41% of advisors surveyed in the CAIS/Mercer study target private credit investments to provide supplemental income to clients.
But Tim Clarke, chief private equity analyst at capital markets data provider PitchBook, said that with the Fed’s key interest rate target now in the 5% range and many funds focused on providing floating-rate loans, private credit currently offers an attractive Return. He noted that while most private credit funds currently pay distributions of about 10%, the best way to measure total returns is to focus on the broader syndicated loan market, which trades every day. Clark said the market will return 13.5% in 2023 and about 11.0% to 12.0% in the first two months of 2024.
“These are stock-like returns and you get them now. You can’t wait until the assets are sold,” he said.
An investor survey completed in November by London-based research firm Preqin showed that 23% said private debt had exceeded their performance expectations in the past 12 months, more than any other alternative asset class. 45% expect private debt to perform better over the next year, up 800 basis points from November 2022. High interest rates are cited as the main reason for this optimism, as investors expect yields to rise.
Research from Morgan Stanley shows that during periods of higher interest rates, direct loan investments have returned 11.5%, while high-yield bonds have returned 7.0% and leveraged loans have returned 5.0%. Meanwhile, losses on direct loans were lower during the height of the pandemic, down 1.2%, compared with 2.7% on high-yield bonds and 1.4% on leveraged loans.
The filings and performance of private credit funds already on the market bear this out.
Cliffwater is a pioneer in providing private credit funds to wealth pipelines. Its flagship product, Cliffwater Corporate Lending Fund, is a private credit interval fund launched in 2019 and currently has $16.4 billion in assets under management. The fund focuses on core private credit opportunities. The company has since launched a second product, the Cliffwater Enhanced Loan Fund, which seeks higher-risk and higher-yield opportunities, including venture loans, royalties and second-lien loans. Cliffwater raises $800 million to $900 million per month from RIAs for its core funds and $100 million to $200 million for enhanced funds, making it one of the top fundraisers in the alternative investments space with limited liquidity.
“From an asset allocation perspective, private debt has a lot of relative advantages over other asset classes,” said Cliffwater CEO Stephen Nesbitt. “Traditional bond yields are close to 4%. Private credit has a 5% to 6% advantage. Relative For stocks, the general consensus is 7% long-term returns. If you can earn double-digit returns on private credit and stocks (priced at 7%), it seems like an easy trade to make. This That’s what you’re seeing today. The cash flow going into private credit is primarily from equity allocations.”
Another product designed specifically for wealth conduits is the Ares Strategic Income Fund, a non-traded business development company that invests primarily in senior, secured, floating-rate loans to U.S. companies. The fund’s Class I shares have returned 13.13%. 2023. Michael Arougheti, chief executive and president of asset manager Ares Management Corp., said on a fourth-quarter earnings call that the company sees continued opportunities in private credit as traditional lenders rebalance their balance sheets after last year’s troubles. expand. Regional Banking Sector.
“Once we get past the first phase of balance sheet restructuring and repositioning, I think a lot of banks — regional banks, supra-regional banks and global investment banks — will rethink their core business and balance sheet positioning. As they go through All of this, we position ourselves as their proven partner. So I think that bodes well for continued deployments,” he said.
Blue Owl Credit Income Corp. is another non-traded BDC with an investment profile similar to ASIF, with a total net return of 15.77% in 2023. The fund raised $1.2 billion in the fourth quarter, a 30% increase compared with last year’s third quarter. 2023.
Marc Lipschultz, co-chief executive of asset manager Blue Owl Capital, noted on the company’s most recent earnings call that the direct lending business remains strong. “We again saw robust deployment trends in the fourth quarter, with the environment remaining constructive into 2024.”
The scale of funds becomes larger
According to Bloomberg, at the beginning of 2023, the total private credit market was approximately US$1.4 trillion. Morgan Stanley predicts that this number could grow to $27 trillion by 2027.
According to data from Preqin, there were 1,072 funds targeting private credit in the global market in December 2023, with a total capitalization of US$456 billion. Last year, a total of 196 private debt funds completed fundraising, raising a total of US$202.2 billion.
More specifically, of the 199 closed-end funds overseen by XA Investments (the funds most likely to be used by advisors), 62 are credit-focused and have $53.2 billion in assets under management.
“Funds now, whether they’re interval funds, BDCs or tender offers, are making it easier to manage,” Cliffwater’s Nesbitt said. “What I’ve learned is that you can have a good product, but if it’s a management Be challenged and forget about it. But if it’s a good product and investors can get in and out, then it’s a home run. We did interval funds because we thought it was the most convenient, but others were offering Bid Fund or BDC.”
Clark said there could be the same amount or more funding targeting private credit this year, with some unusually large private credit funds expected to close in the first half of 2024. For example, Ares Management’s Ares Capital Europe VI is likely to become the largest direct lending fund ever, with $21.9 billion in capital. Larger funds typically have higher minimums, meaning they are typically only open to qualified purchasers or access is available through feeder funds.
“Private equity financing has reached $30 billion. You’ve never seen direct loan funds on this scale,” Clark said.
Gregg Sommer of Mercer pointed out that after the financial crisis, the lending level of the banking industry has never returned to previous levels, resulting in a supply gap, which has also become an opportunity for private lenders. The gap grew wider last year after troubles among regional banks rocked the industry.
“Loans are down. It just increases the opportunities for private credit,” he said. “So I think there are a lot of compelling reasons to think that this trend and our conversations with clients will continue and that allocations to the asset class will continue to accelerate.”
Last fall, global private markets investor Pantheon Group registered an evergreen private credit fund that will focus on debt investments through the secondary market. When the AMG Pantheon Credit Solutions Fund (PSECC) launches this spring, it will be the second investment vehicle launched by the firm’s U.S. Private Wealth arm. Michael Hutten, partner and head of private wealth at Pantheon, said the fund will focus on buying credit positions to provide floating-rate loans in the secondary market to major institutional clients. Hutten noted that investing in the secondary market will allow the company to assess the health of loans with greater certainty, take advantage of shorter loan terms and purchase at current discounts of 10% to 12% on senior loans. Buying at a discount will also protect investors if the market starts seeing larger loan defaults, he added.
Hutten said that these days, whenever he attends industry events, most of the speakers tend to be private credit managers. Individual investors and RIAs appreciate the asset class’s ability to provide healthy income, yields that are currently comparable to long-term public equity total returns, and lower volatility than the public markets. “The demand for private credit is huge,” Hutten said. “Particularly for our fund, we found it to be very complementary to what other fund managers were doing and found there was a lot of demand for the products we were launching.”
Pantheon plans to target the fund’s senior debt income to be comparable to what investors see in the direct lending market, with capital appreciation in the range of 200 to 300 basis points. These estimates are based on the company’s prior experience in the private credit secondary market, where it has been investing since 2018.
What if interest rates drop?
With investors excited about the opportunity to reap excess returns from higher interest rates, what will happen if the Fed starts cutting interest rates later this year, as it has suggested?
In this scenario, private credit funds would make less money but still perform well, Clark said. Lower interest rates could spur more leveraged buyout activity, driving up demand for credit and loan volumes.
Clark noted that one of the biggest risks facing private credit investors today is loans made at the market’s peak in 2021 and 2022. In 2008, defaults rose sharply and floating-rate loans lost 30 percent of their value, he said. Since then, lenders have become more disciplined. But some losses are still possible on loans made after the outbreak when interest rates were near historic lows.
Huten reminds advisors, when making decisions about allocations to private credit funds, to check whether the managers they are working with have experience investing in private credit across multiple cycles. He noted that the environment for the asset class has been relatively benign over the past five or six years, with very few defaults. This may not last forever.
“I think because it has become such a popular area of investment, sometimes allocators forget that these loans are typically made to private companies and there are risks involved in making these loans,” he said.
