Private Credit Is Increasingly Available For Individual Investors, Why It Has Risen To Prominence And How Advisors Can Choose The Right Ones
“If you need a loan, go to the bank.” – This phrase sounds as sensible and obvious as “water flows downhill,” stretching back through financial history in various civilizations worldwide. But in the modern era, this tenet no longer holds. In recent years, banks made fewer loans while investment managers with the backing of institutional and individual investors rose as lenders.
Known as “private credit,” this trend toward investment manager-led loans accelerated in the aftermath of the Global Financial Crisis (GFC) and gained a further boost in the past year as advisors searched for alternative investments.
To learn about private credit, we caught up with Mark Gatto, Co-Founder & Co-Chief Executive Officer of alternative investment solutions provider CION Investments, which sponsors a business development company that manages approximately $1.9 billion in assets and focuses on senior secured debt of middle market companies under $75 million in EBITDA, as well as a $3.6 billion interval fund that invests in global credit assets.
Gatto describes the history and growth of private credit, its increasing access for individual investors, a 2023 outlook and how advisors should choose private credit investments.
WSR: Provide a brief history of private credit. How did it evolve and what position does it hold in the debt markets? What does the typical invested company look like?
Gatto: The largest private credit strategy, by assets, is direct lending to middle market private companies. These companies historically accessed bank funding for capital needs. For the last several decades, banks have exited this market as the banking industry consolidated into larger players. This was accelerated by regulatory changes after the GFC. According to Refinitiv, banks accounted for 58% of deals in 2013, and as of 2021 this fell to 11%.
Asset managers filled the void, creating a new asset class that has seen dramatic growth. Preqin reports private credit assets under management of $1.2 trillion in 2021 and growth that averaged 13.5% annually since 2010. The asset class is projected to grow at an annual rate of 17.4% between 2022 and 2026.
Middle market companies typically generate between $10 million and $1 billion of annual revenue. According to the National Center for the Middle Market, in 2021 these companies comprised 48 million jobs and more than $10 trillion in gross receipts.
WSR: How did the opening to non-institutional investment occur?
Gatto: Institutional investors have accessed the benefits of credit alternatives in their portfolios for decades, but usually at investment levels and in structures that were out of reach for individual investors.
The innovative deployment of the interval fund structure for private credit funds created access
for individual investors. Interval funds allow redemptions at intervals, usually every three, six or 12 months. This limited liquidity can be an effective compromise between the needs of the manager to execute a long-term strategy and the liquidity needs of an investor. Interval funds can also offer low minimums to investors without qualifications, and simple tax reporting.
WSR: Why is private credit growing in popularity with non-institutional investors? With private companies?
Gatto: 2022 saw a broken 60/40 portfolio as equities and bonds moved in tandem, and in the wrong direction. Investors were reminded that the negative correlation of equities and bonds isn’t guaranteed. With volatility higher, the need for true portfolio diversification has accelerated the demand for alternatives. The potential to add diversification and yield without ratcheting up risk is one of the benefits of private credit.
We’re seeing a trend of a flexible allocation that adds alternatives by reducing both the equity and bond side of a traditional portfolio. For example, KKR recently published a piece outlining a 40/30/30 portfolio that puts real estate, infrastructure and private credit into the allocation.
Private companies are attracted to working with non-bank direct lenders instead of banks because of the package direct lenders can provide. The structure of deals, including the terms and rates, are very competitive compared to banks. The speed at which a private lender is able to move is significantly quicker than a bank, and private companies have much more certainty that a deal will close.
WSR: What is the 2023 outlook for private credit, especially considering the slower growth and possible recession anticipated this year?
Gatto: The outlook for the asset class is one of growth, as noted above, because investors are seeking diversification and more stability in their portfolios. We know from recent history that middle market companies, which underly private credit, are uniquely resilient. The National Center for the Middle Market reports that during the GFC, the middle market added over 2 million new jobs. In comparison, large businesses eliminated 3.7 million jobs.
We are likely in for a normal default cycle, as defaults have been historically low and are rising. However, the structure of private credit mitigates the default risk. These are senior, secured loans. They sit at the top of a company’s capital stack and are secured by company assets.
Additionally, the loans are governed by covenants that ensure the interests of the lender and the company remain aligned. Covenants on the loan work to ensure the lender can provide oversight and assistance if a rough patch arises, as happened during 2020-21. The resilience of private credit during that period can help provide some insight into what may happen going forward.
WSR: What should advisors be wary of when choosing private credit investments?
Gatto: Investors shouldn’t lose sight of the basics of credit investing – it’s about avoiding mistakes. Defensive positioning and very strong underwriting standards should be the core. For individual investors, it’s all about choosing the right manager.
As the asset class grows, and more money creates more dry powder, deal quality may decline. It’s important to work with a manager that has proven experience and the ability to select the best deals and impose meaningful covenants.
James Miller, Contributing Editor & Research Analyst at Wealth Solutions Report, can be reached at ContributingEd@wealthsolutionsreport.com
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