Private Credit – What It Is and Why We Allocate

Over the past few years, the private credit asset class has been a hot topic among investors. A combination of historically high interest rates, along with a pullback in lending from many commercial banks, have created durable tailwinds within the asset class. As the Federal Reserve has chosen to leave interest rates higher in the face of stubborn inflation, the current market sentiment expects “higher for longer," which benefits investors in private credit. Looking at the specifics will uncover why private credit has recently been a focal point of allocation for investors and why we believe the asset class should be incorporated into portfolio construction, provided it meets client goals and objectives.

 Private credit, also commonly referred to as private debt, consists of privately negotiated loans provided by non-bank lenders. These privately negotiated loans are priced at a spread over the Secured Overnight Financing Rate (SOFR) of 4–7%, resulting in a yield of approximately 9–11%. While these loans can be more expensive for the borrower compared to bank financing, there are many advantages to accessing capital through the private credit markets. For example, tailored lending solutions can be created by firms that specialize in private credit strategies (i.e., Blackstone, Ares, Apollo, KKR, etc.). These firms can typically fund loans quicker than bank financing, and there is an extra layer of privacy for borrowers as they can obtain capital without publicly disclosing their financials or strategic initiatives.

There are strategic advantages for investors in private credit. Given current interest rates, yields from private credit funds are on par or better than expected equity returns. Additionally, loans within the asset class are typically “senior secured” and collateralized by the borrower’s assets, helping mitigate risk in the event of a default. What this boils down to is a more favorable risk/return tradeoff for private credit when compared to equities. Note that there is still risk with private loans, and they are not rated by agencies such as Moody’s or Fitch.

A key feature of these loans is their “floating” interest rate, meaning if rates go up (as measured by SOFR), the borrower’s rate also goes up, leading to investors earning more money. And by the same token, if SOFR goes down, then the borrower pays less and the end-investor receives lower income. While today’s higher rates make these loans attractive from a yield/return point of view, it is worth emphasizing it does create additional stress for the borrower. This additional stress is why we believe it is imperative to select managers with strong credit underwriting abilities to mitigate risk where possible.

To quantify the risk, we monitor interest coverage ratios. This specific ratio is derived from dividing a company’s earnings before interest, tax, depreciation, and amortization (EBITDA) by their interest expense. These interest coverage ratios have been an ongoing concern in recent years, as a rapid rise in interest rates in 2022 has led to a deterioration of many borrower’s interest coverage ratios from just above 3 to now just shy of 2 – despite a strong economic environment (Cai & Haque). For reference, a ratio below 1 indicates a borrower does not generate enough cash flows from operating business to make interest payments. Another area we have identified as a concern within the private credit space is the competition of new firms entering the business. The subsequent risk with this influx is that rates and covenants can be looser than normal, which lowers the expected return and increases the risk for the investor. While this scenario has the potential to negatively impact investors, we mitigate this risk by placing a substantial emphasis on fund managers with well-established and disciplined credit underwriting teams.

We remain steadfast in our belief that the private credit asset class represents one of the best risk/reward tradeoffs available today. Although the deterioration of interest coverage ratios has created a cause for concern, overall leverage has come down, improving the collateral coverage of the loans. We continually rely on our robust manager selection process to ensure our client portfolios are positioned appropriately. Furthermore, we emphasize managers with strong internal work-out teams to enhance the recovery amount in the event a company defaults.

To provide clients with the best possible experience when investing in private credit, we typically invest through “liquid alternatives”, which are fund structures that provide access to private credit while also preserving liquidity (Interval Funds, Business Development Companies, etc.). These fund structures are required to have special liquidity provisions that provide a certain percentage of fund net asset value to investors each quarter (typically 5%). Additionally, these funds report taxes via 1099 rather than form K-1, which simplifies tax reporting for investors.

Of course, private credit does not have a place in every portfolio. At LGT, we believe a diverse portfolio tailored to your specific goals and objectives is the best strategy. Our team is ready to help guide your decision-making process, and we invite you to have a conversation about your wealth management needs at any point in time.

To learn more about private credit, contact one of our trusted advisors.