Alternative Investing: Private Credit on Growth Trend
Senior direct loans, or loans to companies arranged by private fund managers, have become increasingly attractive for investors and contributed to the growth of private credit.
- Fixed Income Insights
- Alternative Insights
- Private credit
- Markets & Economy
Key Points
What it is
We explain why senior direct loans have helped drive growth in private credit.
Why it matters
Senior secured direct loans typically have offered a more stable yield profile and a higher yield premium over other types of loans.
Where it's going
Potential for strong risk-adjusted returns has attracted plenty of investor interest to these loans, but due diligence is critical.
The market has grown significantly in recent years, taking market share from traditional banks, a trend that has been occurring since the Global Financial Crisis. Private credit is a broad term and can include a number of different strategies, all with different risk/return profiles. Despite the strong historical growth, we believe a long runway continues to exist for the asset class due to what we believe are the attractive features it offers to investors. Supporting this growth, we think investors have found that rising yields over the past two years have created an attractive risk-return profile for senior direct loans. Let’s take a closer look.
Direct loan funds are a type of private fund where investment managers directly negotiate loan terms with borrowers, often to mid-sized companies. These funds can range in strategy from senior secured loans, to unsecured mezzanine debt, or specialty forms of financing to distressed credit. Senior secured loans typically are floating-rate, first lien loans, that historically have offered a more stable yield profile and a higher yield premium over more broadly syndicated loans to larger corporations. Companies are increasingly relying on the direct-lending market for financing as banks have tightened their credit standards. We find that company owners appreciate the ease of working with a smaller group of non-public lenders. In fact, the volume of these loans is at more than five times the volume of syndicated loans to larger companies, a ratio hovering at the highest on record. We believe the demand for private credit loans from both investors and fund managers has positioned direct loans for continued growth.
One of the key attractions for investors is the floating rate nature of these . Yields for these loans have reached the highest in more than a decade, thanks largely to the rise in base interest rates, but also due the strong demand from borrowers. We think these loans offer attractive cash income to investors looking for an alternative to traditional fixed income investments in their portfolios. Despite a rise in interest rates over the past two years, we think deep due diligence conducted by the lenders have kept defaults from rising significantly. Relative to public forms of financing, privately negotiated loans can offer stronger lender protections and documentation, and a relatively more efficient workout process and principal recoveries in the event of a loan default. These trends support the improving risk-return profile of these loans, which we think has drawn the attention of investors and we expect that to continue into 2024. We are particularly focused on senior loans, which is the most protected part of the capital structure should the markets continue to experience volatility and future uncertainty as the result of broader macroeconomic and geopolitical issues.
While the potential for strong risk-adjusted returns of these senior loans has attracted plenty of , we think successful investing in this market requires rigorous due diligence since not all lenders are created equal. We believe fund managers with a long and successful track record, disciplined underwriting standards, strong loan origination networks, and demonstrated skills will be better positioned to preserve the attractive risk-return profile into the future.
A loan workout is the negotiation between a lender and a borrower to revise the debt payment plan when the borrower cannot make a payment.
Private credit refers to nonbank financial entities making loans to borrowers.
Senior debt has the first claims on a company's cash flows, with priority over subordinated debt, and often has first claim on a company's property, plant or equipment in case of default.
The first lien means that the lender holds the first claim on a company's collateral for debt repayment in case of default.
Main Point
Attractive Risk-Return Profile
We think investors have found that rising yields over the past two years have created an attractive risk-return profile for senior direct loans, one type of private credit investments. Yields for these loans have reached the highest in more than a decade, thanks largely to the rise in base interest rates, but also due the strong demand from borrowers.
Navigating High-Yield Credit Opportunities in a Resilient Market
Bob Morgan
Managing Director, 50 South Capital
Bob Morgan is a managing director for 50 South Capital, with management responsibility for the alternative asset investments areas of 50 South Capital. He was previously the director of private equity, a position he held since co-founding the private equity funds group, and an area in which he remains heavily involved.
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