Private Credit: Does the Hype Still Warrant an Allocation?

by
Leo Wealth

Written by Jason Gibbons, CFA

Private Debt has amassed over $1.7 trillion in assets under management, doubling in size since 2019. Inflows and growing leverage have fueled growth during a period of rising rates and economic growth. The perceived fear in this asset class, centers around the growth, deployment and ability to protect investments in economic downturns. Does Private Credit still warrant an active allocation? The answer is a resounding yes through ultra-selective manager due diligence, allocation to suitable types of credit and other factors.

The growth of the asset class has led to competition on pricing, covenants and an alternative to traditional bonds. This has led to questions on where and how managers are allocating capital. Are large strategies able to effectively deploy capital into private direct lending? Is an advertised first-lien senior secured strategy actively straying into higher-risk, less protected loans? Are covenants offered enough to protect lenders and investors?

Strategies with large amounts of dry powder are competing in what has turned into a borrower’s market. The loan spread lenders are now receiving have compressed 1.5%+ over the past two years. Financial covenants, lender’s ability to monitor and act on an underperforming business, have slowly eroded with increased competition. Other underwriting standards have also deteriorated. Increased amounts of leverage and lower thresholds of the borrower’s ability to cover interest payments have both come off recent historical trends. A historical starting 2.0x+ interest coverage ratio, is now underwritten closer to 1.5x for larger deals. Manager’s ongoing mark-to-market of underlying loan values is also a point of contention. While illiquid in nature, managers that hold the same loans often mark the values differently.

The aforementioned reasons underpin the necessity of enhanced manager due diligence and selection. We approach manager selection in navigating away from overpriced, overlapping, and lower in the capital stack strategies. Core middle and lower middle market focus offers an attractive risk-adjusted opportunity and less seeing less competition. Including some fixed rate, shorter duration Asset Backed Lending is an attractive play on falling interest rates. Favoring managers that will forgo equity warrants for lower loan leverage and tighter financial covenants, is attractive tradeoff. Strong visibility into deal flow, underwriting teams, workout experience and knowing strategy limitations are key. Private Credit remains an attractive part of asset allocations, but the right due diligence and positioning are paramount.


DISCLOSURES

The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information.  Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses.  They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.

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