Private credit has emerged as a compelling option for investors seeking substantial, stable cash flows from low-risk investments. This month, I want to delve into the nature of private credit, its risk characteristics, and why it might be a suitable addition to your investment portfolio.

Understanding private credit

Private credit refers to debt financing not traded on a public exchange. It involves direct lending to companies, bypassing traditional banks. Over the past 10 to 15 years, the market has evolved significantly, allowing lenders to connect directly with borrowers. This direct connection eliminates the intermediary role of banks, providing more customised loan solutions.

Not all loans are created equal

Private credit consists of various types of loans, each catering to different borrower needs and risk profiles. First lien loans occupy the highest priority in the capital structure, which provides a higher level of security compared to other forms of debt. In the event of a company's liquidation, first lien loan holders are the first to be repaid from the proceeds of the sale of the company’s assets. We’ll be focusing on first lien debt.

The security of first lien debt

First lien loans have historically demonstrated lower default rates compared to other forms of debt. For example, Hamilton Lane, a leading private markets investment manager (and the fund manager of StashAway Reserve’s Private Credit), reported a 0% default rate on their first lien senior secured loans over a 22-year track record.

A study by S&P Global Market Intelligence in 2022 showed that first lien loan default rates were around 1.5%, significantly lower than the 3% average for all leveraged loans.

Default doesn’t necessarily equal loss of money

Default rates are always a concern for credit investors. According to S&P Global’s research house, US default rates are expected to rise to 4-4.5% by the end of the year, but this is still within manageable limits for high quality loans. Furthermore, senior secured loans generally boast lower default rates compared to public debt. First lien senior secured loans typically have much lower default rates. 

Even in the event of a default, first lien lenders have several mechanisms of recovery:

• Liquidation of assets: Since first lien loans are secured by the company's assets, lenders have the right to seize these assets to recover their funds. This process ensures that first lien lenders are repaid before other creditors.
• Restructuring: In some cases, lenders may work with the company to restructure its debt. This could involve modifying the terms of the loan, extending the repayment period, or converting debt into equity. Such efforts aim to improve the company's financial health, enabling it to meet its debt obligations.
• Bankruptcy proceedings: If liquidation or restructuring is not viable, the company may file for bankruptcy. During bankruptcy proceedings, first lien lenders have priority over other creditors in the distribution of the company's remaining assets.
• Recovery rates: Historically, first lien lenders have achieved higher recovery rates in default scenarios. Recovery rates for first lien loans typically range from 70-80 cents on the dollar, reflecting the secured nature and priority status of first lien loans compared to other debt types.

The recovery rates for first lien loans are typically higher, with investors often recovering 70-80 cents on the dollar in the event of a default. This data underscores the lower risk profile of first lien loans within the broader private credit landscape.

A resilient risk-returns history

One of the most attractive features of private credit is its return resilience – outperforming public markets in 21 of the past 22 years. It has consistently shown positive median returns, even in down markets, with a relatively narrow dispersion of outcomes. This stability makes it a reliable investment option.

Even in the worst five-year period over the last 28 years, private credit still generated a 4.5% annual return. This contrasts sharply with many public market equivalents, making it a safer bet for conservative investors.

As an investor, what should you look out for?

Quality and selectivity: Risk management in private credit heavily relies on the quality and selectivity of the deals. Investment managers like Hamilton Lane review thousands of deals annually but select only about 7%. This high level of selectivity ensures that only the most promising and secure loans are chosen. High-quality funds with rigorous due diligence are more likely to offer secure and profitable investments.

Understanding the market: Investors should understand the distinctions between different types of private credit, such as corporate lending and asset-backed loans. This helps in choosing the right investment products to align with your investment goals and risk tolerance.

Interest rate environment: The current high interest rate environment makes private credit particularly attractive, offering returns around 10% or higher, being a combination of base rates and additional spreads. Rates are expected to remain high for the next few years, ensuring that private credit will continue to post strong returns relative to other investment options.

Focus on senior secured loans: Investing in senior secured loans, particularly first lien loans, provides an additional layer of security. These loans have historically shown 0% default rates for some investment managers, highlighting their robustness.

Unlocking the potential of private credit

Private credit has now transitioned from closed-ended funds with long lock-up periods to more accessible, semi-liquid structures offering monthly liquidity. These new structures provide better liquidity options for investors, making private credit a more flexible investment.

Adding private credit to a well-rounded portfolio can further diversify it, reducing overall risk while enhancing returns. This diversification effect is due to the low correlation between private credit and other asset classes. 

In the table below, notice how the Sharpe ratio (a measure of risk to returns) improves as the allocation to private market investments increases.

All in all, first lien secured private credit offers a unique blend of low risk and high returns, making it an excellent option for conservative investors seeking stable and reliable investments. By understanding the nature of private credit, its risk characteristics, and how to manage those risks, investors can make informed decisions to include this asset class in their portfolios.