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Private credit

Randy Schwimmer
Co-Head of Senior Lending
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Private credit

Middle market private lending has surged in popularity since the Global Financial Crisis. U.S. senior middle market loans have typically yielded between 6% and 8% since 2010, and the illiquidity premium between middle market loans and broadly syndicated loans has averaged 1.8% during that period, according to LC/S&P Global.

This has provided a boost to yields, making middle market loans an effective alternative source of income with a risk profile that varies significantly from other types of debt.

Considerations for risk factor-based investing

 
Minimizing losses is the name of the game 
The upside for private credit investments is limited simply because of the nature of these instruments. As a result, minimizing losses is paramount. The U.S. middle market is enormous, with nearly 200,000 companies generating approximately $6 trillion in revenue, according to the National Center for the Middle Market. If the U.S. middle market were its own country, it would have the world’s third-largest GDP. This is a massive pool for middle market lenders to operate in, meaning that deal selectivity for lenders is key.

Conservative structuring provides a level of protection 
Middle market loans are typically more conservatively structured, with lower leverage multiples, higher interest coverage and tighter covenant packages than broadly syndicated loans. Most importantly, private credit assets are illiquid and do not trade. This distinguishes them positively from larger, liquid public assets, which are more volatile because they are marked to market. Consequently, middle market loan yields have been more stable through multiple business cycles.

Illiquidity premium fuels middle market loans’ attractive yield 

Pay close attention to sponsor behavior 
In addition to evaluating the company and its sector, lenders should scrutinize the private equity firm that is backing the company. We recommend only lending to companies where private equity accounts for at least 50% of the capital structure. This creates natural alignment between the lenders and financial sponsors, who are the primary source of long-term capital for the business. By observing how sponsors have behaved when their other portfolio companies have run into trouble, a lender can get a sense for whether the sponsor will be committed to reinforcing a company during a downturn. 

Beware of covenant-lite documentation 
When lending to middle market companies, covenants provide an important layer of protection for lenders. In the years preceding the coronavirus pandemic, lenders became increasingly aggressive to win deals, often offering borrower-friendly terms and covenant-lite documentation. We believe that this was a perilous trend for middle market lenders.

Customization provides multiple levers for accessing idiosyncratic risk 
The high levels of customization available and negotiated loan origination inherent in private credit allow investors to access idiosyncratic risk and alpha generation potential. For senior private credit specifically, the floating rate feature enables the investor to distinguish credit risk from duration risk. Additionally, senior private credit investments have shown a relatively high correlation to inflation. This provides inflation-hedging properties not typically found in fixed income investments.

Figure 4: Risk measures vary by asset class 

COVID-19 impact: Headwinds create opportunities for nimble managers


Private credit has seen a dramatic halt in deal activity, and investors’ focus has shifted to understanding how portfolio companies — and their financial sponsors — are dealing with the crisis. This type of environment highlights the need to pay close attention to sponsor behavior and assess whether they are being a constructive partner and providing incremental capital to companies that are otherwise well-positioned.

We expect to continue to see attractive opportunities in senior secured loans to sponsor-backed, middle market companies going forward. The best time to deploy capital is often during the most challenging market environments, and we believe that this crisis will present some of the most attractive opportunities we have seen in years from a risk-adjusted returns perspective. Liquidity will be key to capturing opportunities in this environment.

The crisis highlights the benefits of working with private credit managers who have scale, capital, strong relationships and the ability to act quickly. These managers will be best positioned to both support existing portfolio companies and benefit from attractive opportunities as they emerge.
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Endnotes 
Sources 

All market and economic data from Bloomberg, FactSet and Morningstar. 

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, or liability for, decisions based on such information, and it should not be relied on as such. 

A word on risk 

All investments carry a certain degree of risk, and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. In portfolios that include lower-rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for nonfinancial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not suitable for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy. 

Nuveen provides investment advisory services through its investment specialists.