How to build dependable diversification with private credit
How to build dependable diversification with private credit
The private credit market is vast and varied, and each opportunity is unique in its attributes. As such, it represents an abundant source of diversification for investors seeking a less correlated, more secure income stream.
What are “typical” private credit assets?
The universe of private credit assets available to investors has expanded rapidly over the past decade, which makes defining a “typical” private credit a challenge. More stringent capital requirements mean banks have withdrawn from the traditional roles they have played in financing a broad range of asset classes. This has supported a new suite of options – from private corporate debt to infrastructure debt, commercial real estate debt and many others – to the benefit of institutional investors.
Figure 1. The private debt investment landscape
Source: Schroders, Illustation only, 2021
Direct lending – driving the growth of the private credit market
While defining a typical private credit is difficult, direct lending has been the largest contributor to the growth of private credit since the global financial crisis. Direct lending is the provision of secured (by cashflows) loans to (typically) middle market, sub investment-grade borrowers. Today it represents the largest sub-segment of private credit by assets under management.
Since 2009, direct lending has grown 26% per annum according to Preqin, and represented $452 billion of assets as at March 2021. The US represents the largest and most established market, representing more than 50% of that global figure. However, core markets like the UK, Germany and France are also large markets for direct lending.
The structural changes – mentioned above - that have led to an increase in private credit can be very clearly illustrated in the US market via the decline in the number of banks operating in this segment. This has partly been a result of consolidation, but also regulatory changes. It’s simply more difficult and less profitable to operate as a bank in the US.
At the same time, owners of these middle market companies increasingly require speed, certainty of execution and more flexible lending solutions. This has led to a change in the makeup of the lender market in a key area like the US. Banks are seeing a significant decrease in their share of lending to private equity backed transactions, from close to 50% in 2000 to ~10% now.
Figure 2. The changing lender market
Source: FDIC, S&P LCD, Schroders, 2021
Interestingly, there is a diverse range of investment structures and solutions within the direct lending market. The graphic below outlines the key transaction structures found in the direct lending market.
Figure 3: Direct Lending Menu – Multiple options available
Why diversification is abundant in private credit
Beyond the core elements of private credit markets mentioned above, such as direct lending, there is the potential to create portfolios of multiple underlying sub-asset classes within private credit.
In a bid to enhance returns while maintaining strong downside risk protection, investors are looking into solutions they have not considered before.
Investors can achieve a truly customised, diversified private credit portfolio thanks to the depth and breadth of private credit markets.
Diversified private credit portfolios enable investors to access underlying asset classes that would traditionally have been the preserve of banks or much larger pension schemes.
Broadly speaking, diversification can be viewed in multiple ways.
1) Sub-asset diversification - combining private direct lending with real estate debt and infrastructure debt.
2) Underlying borrower diversification - to ensure losses are not amplified throughout a portfolio.
Often idiosyncratic in nature, the underlying asset classes in private credit also diversify well, against both each other and traditional liquid components of institutional portfolios. This means in combination they can dampen portfolio volatility and enhance the overall risk/return profile of a pension scheme. This is illustrated below by the low historic correlations between a selection of private and public assets.
Figure 4. Estimated correlation vs. other comparable credit and equities, 2008 - 2020 (in £)
Source: Schroders, 2021
For small and mid-sized pension schemes who may lack the scale and/or governance budget to make allocations to multiple, discreet asset classes, a diversified private credit approach can offer an efficient means of exploiting private markets.
Resources and strong investment processes and governance frameworks are needed to effectively source, underwrite and monitor private credit investments as they tend to have different characteristics versus more traditional fixed income assets.
Access is another key consideration. Many leading private credit managers raise capital through closed-end structures that have limitations on investor allocations and also have minimums that might prohibit smaller investors from investing.
Given these dynamics, it is imperative to have full market coverage and dedicated resources in place to maintain active and consistent outbound sourcing of investment opportunities.
Return profile enhanced via diversification
In addition to the benefits inherent from a lack of correlation in various private credit sub-asset classes, there is also benefit from combining multiple income and return streams that are tied to a diversified pool of underlying collateral and assets.
Figure 5: Uncorrelated collateral pools drive strong downside protection
Source: Schroders, illustration only
As spreads are cyclical in nature, a dynamic approach to asset allocation can also help investors find relative value in the market through time.
A diverse income stream supported by various collateral types also provides a higher probability of strong risk-adjusted returns in an investor’s portfolio. Diverse portfolios in private credit can take advantage of the expected return profiles of various sub-assets, all of which have their own unique underlying risk and return profile. Having the flexibility to dynamically and strategically allocate to different sub-asset classes of private credit within a diversified portfolio creates an attractive access point and diversifies a portfolio by geography, underlying collateral, cash flow stream and market segment. This fundamentally should position a portfolio for strong returns. One such approach is illustrated in the following hypothetical portfolio level return analysis.
Figure 6. Complementary components provide for strong returns
Right place, right time
Investment options within the private credit market have expanded rapidly in recent years. At the same time, the proposition of enhanced return with strong downside protection and low loss ratios has appealed to many investors. The challenge, however, is accessing the right pockets of the private credit market, at the right times, and with the right risk profile.
We believe investors should take advantage of private credit’s diversified cash flow streams, supported by non-correlated underlying collateral. Such a portfolio, in our view, is a highly efficient and productive way make use of a growing and highly complex asset class.
 Source: Preqin, represents direct lending strategies including senior debt, unitranche debt, junior/subordinated debt and blended/opportunistic debt
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