Investing in private credit – what is it and where does it fit into an alternative investment portfolio

News: Insight & Opinion | 31 May 2022

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'In just over a decade, private credit has gone from niche to mainstream, with $1.2trillion of assets now under management globally – a figure which is forecast to double by 2026', says Claire Madden, Managing Partner.

Since the global financial crisis in 2008, private credit has been gaining rapid momentum as a credible, appealing alternative asset class. In the space of just over a decade, it has gone from niche to mainstream, with $1.2trillion of assets now under management globally – a figure which is forecast to double by 2026, according to data provider Preqin¹.

As investors consider their options for portfolio diversification, more relevant than ever during the current challenging economic environment, they should understand what private credit investing is and how it fits within the spectrum of alternative investments.

What is private credit or private debt?

Private credit (also known as private debt or direct lending) essentially means lending which is provided by sources other than traditional high street banks. The term can refer to lending to consumers and to businesses, and it can also refer to property lending.

After banks’ abilities and risk appetites to lend to new customers – and especially to small and medium-sized businesses (SMEs) - were severely curtailed in the aftermath of the financial crisis, a gap in the market was created, allowing alternative lenders to step in to service the financing needs of these businesses.

The dislocation led to a great surge of innovation, to the extent that today the private credit marketplace comprises many providers and covers a wide variety of lending types. These range from peer-to-peer lending to private credit funds specialising in a whole host of strategies, and even hedge funds are getting in on the action. The breadth of strategies under this umbrella offers those opting to invest in private debt access to a wide range of returns and plenty of diversification.

What are the investment returns from investing in private debt?

Private debt can offer investors attractive risk-adjusted returns, which are less correlated with the performance of public markets, and provide regular income payments. The range of those potential returns correlates with the type of debt provided and its position in the ‘capital structure’ or ‘capital stack’, this dictates the order capital is returned to investors/lenders in the event of bankruptcy.

Senior debt (often provided by a bank) is the first in line, making it lower risk. Target gross annual returns from a senior debt investment are around 4-7%. This is followed by unitranche debt (8-14%); and then mezzanine debt (15-20%). Followed finally by equity (higher risk, higher return prospects as it is last in the capital stack).  

The opportunity set when lending to businesses

Our primary focus here is SME lending. There are the large global institutional sized lenders like Blackrock and Ares Management running substantial private credit funds in the corporate credit space, lending to huge companies. But, as in private equity markets, there are plenty of opportunities for smaller, specialist funds lending to small and mid-sized companies, where there is often less competition on debt pricing, meaning better risk adjusted returns for investors.

Some take the place of a bank lender in sponsored private equity transactions to provide senior debt, but with enhanced economics to create mezzanine-style returns. Other SME debt funds invest in sponsor-less transactions, which means they lend direct to smaller businesses, but not as part of a private equity deal, for example, to provide growth capital or as part of a refinancing.

Then there are funds that target other aspects of the market, like asset-based lending (where a business borrows against its assets), receivables lending (where it borrows against the value of its unpaid invoices), and capital projects lending (where long-term finance is based on the projected revenues of a capital-intensive investment project once completed).

Flexible debt, tailored to SMEs needs

In the UK, data from the Alternative Credit Council (ACC) indicates that around 2,000 British businesses are currently receiving some £100billion in total of private credit from asset management firms in this space, demonstrating what an important source of funding it has become². The impetus for SMEs to seek private credit has changed in recent years. No longer is it principally driven by a lack of access to bank lending – instead, many SMEs are attracted by the greater flexibility it offers them, compared to the rigid constraints of banks’ standard terms and conditions.

That flexibility could take the form of loans that are structured to allow for interest to roll up into one final bullet repayment at the end of the term, instead of the usual amortising loans that banks offer. This provides more headroom for growth as the company is not encumbered with regular capital and/or interest payments.

Loans that allow for payment holidays in certain circumstances without penalty, or impose lighter covenants on the business, putting it under less pressure to continually demonstrate it is conforming to strict requirements can also be attractive to borrowers. In the past two years, when changeable trading conditions have put budgets under constant review and necessitated a regular re-adjustment of forecasts, that has proved more valuable than ever.

For many SMEs, the higher interest rates payable on private credit agreements are well worth it to achieve this flexibility and to ensure that loans are tailored specifically to suit their unique needs. Instead of endlessly focusing on paying down debt and worrying about whether they still meet covenant tests, they have space to concentrate on running and growing their business, and ultimately creating value.

From an investor standpoint, offering that flexibility need not mean an increase in risk. Indeed, because SMEs are prepared to pay a higher interest rate, the targeted return is, therefore, higher, ultimately creating a more attractive risk-adjusted return. Some private debt deals may also include a small equity share in the company: not as much, clearly, as in a full private equity deal, but some degree of ‘equity kicker’ to further enhance returns potential (to around 10%-15% annualised) and share in any upside as the company grows.

Our approach to private credit investing

Investment opportunities in private debt

At Connection Capital, our clients can invest in private credit deals directly in UK SMEs (which we originate, structure and manage), and also invest in specialist private debt funds. These are operated by fund managers that we believe have the expertise to spot and capitalise on good opportunities in the marketplace – whatever the specific private debt strategy.

One of the first offered to our clients was the Beechbrook Private Debt II Fund back in 2014, a pioneering mezzanine finance fund specialising in providing leverage for private equity deals. Fund managers recognised soon after the credit crunch that attracting senior bank debt for private equity transactions would be challenging for some time, so there was a real market opportunity for a specialist debt fund to fill the gap. Demand for Beechbrook’s solution was indeed strong and we supported its third fund in 2016.

We were similarly struck by the scale of the opportunities presented by the LendInvest Income Fund, in which our clients participated in 2014. In this example, an experienced team had identified strong demand for real estate bridging loans which could be put in place quickly (including thorough due diligence) to give borrowers time to agree cheaper finance with traditional bank lenders who took longer to process applications. LendInvest was able to carve out an early dominant position in a fragmented marketplace where the quality of providers was generally poor. It is now the clear market leader in its field. In both cases, significant value was created for our private investor clients.

More recently, our model of investing in niche strategies run by high-calibre fund managers has seen our clients investing in the BCI Credit Opportunities Fund which lends to emerging fintech businesses, and the SCIO European Secured Credit Fund III which targets the underserved sub €25m loan market segment in Europe. Not to mention 17Capital Fund 5, a private equity liquidity fund with an investment strategy capable of generating attractive mezzanine-style returns, but for a risk level that is akin to that of senior debt.

Special situations credit, where funds step in during periods of dislocation to buy debt and restructure businesses to put them back on a firmer financial footing, has also been an area of interest to our private client investors in the current challenging trading conditions. Examples include the Blantyre Special Situations Fund I, and the Invesco Credit Partners Fund II.

For SMEs, the need for flexible finance has arguably never been greater, and there is a clear drive from investors (including private high net worth investors) to seek out portfolio diversification opportunities across a broader range of sub-segments of the alternative investment space, putting options like SME lending and property finance squarely on their radars. At the same time, as the market has matured, there are many highly innovative and experienced fund managers out there if you know where to look. All in all, it makes for a very interesting and appealing asset class – no wonder AUM are growing so fast!