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Private credit: Middle market opportunities to meet today’s challenges
Private credit has historically been an attractive investment
Historically stable performance and broader knowledge of the asset class have driven an increasing amount of capital into the space.1 In today’s low-rate, late-cycle environment, institutional investors are struggling to deliver yield, drive growth and meet liabilities. We believe private credit may be an effective alternative source of income, while providing true diversification.
Middle market loans — with credit risk comparable to broadly syndicated leveraged loans and high yield bonds — have historically boosted portfolio yield, due in part to the illiquidity premium and other factors. The illiquidity premium for middle market loans currently is running just under the long-term average of 1.8%, but remains attractive at 1.0%.
In our view, private markets are an attractive way to generate portfolio growth through uniquely structured opportunities. The high levels of customization available and negotiated loan origination inherent in the asset class allow investors to access idiosyncratic risk and alpha generation potential.
Middle market loans are typically more conservatively structured with lower leverage multiples, higher interest coverage and tighter covenant packages than broadly syndicated loans.
And, most importantly, private credit assets are illiquid and don’t trade. That distinguishes them positively from larger, liquid, public (yet more volatile) assets that are correlated with market moves. Middle market loan yields have therefore been more stable through multiple business cycles.
Private credit can play an important role in all types of portfolios to manage different risks and achieve different objectives. The key for investors is to understand the drivers of risk and return relative to other portfolio exposures.
In our view, it is essential to remain highly selective and focused on building diversified portfolios of loans with 1% to 2% position sizes, conservative leverage multiples, significant sponsor equity contributions and at least one financial covenant per transaction.
Structuring a private credit deal requires more than just private equity. Originating the loans is a key part of the investment process, and most managers have a loan origination function that entails an active strategy unto itself. We align ourselves with top-tier private equity sponsors with decades of investing success.
1 Data source: Cliffwater Direct Lending Index (CDLI), 01 Jan 2005 to 31 Dec 2019.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.
Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Correlation is a statistical measure of how two securities move in relation to each other. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation (a correlation co-efficient of -1) means that securities will move by an equal amount in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; their movements in relation to one another are completely random. Covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend. Earnings before interest, taxes, and amortization (EBITA) refers to a company’s earnings before the deduction of interest, taxes, and amortization expenses. It is a financial indicator used widely as a measure of efficiency and profitability. S&P/LSTA Leveraged Loan Index is designed to reflect the performance of the largest facilities in the leveraged loan market. S&P Middle Market Index provides investors with a benchmark for mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.
A word on risk
Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Please note investments in private debt, including leveraged loans, middle market loans, and mezzanine debt, are subject to various risk factors, including credit risk, liquidity risk and interest rate risk.
This information represents the opinion of Nuveen, LLC and its investment specialists and is not intended to be a forecast of future events and or guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. There is no assurance that an investment will provide positive performance over any period of time.
Nuveen, LLC provides investment advisory services through its investment specialists.