Opportunities and positioning
The asset class continues to be a good match for long-term investors, especially those with long-term liabilities. It’s worth noting that while generally less liquid than publicly listed assets, private credit offers a premium for this illiquidity.
When the next economic and broad market downturn inevitably arrives, we believe senior middle market loans could provide investors access to attractive yields from relatively conservative assets with inherent downside protection.
We remain focused on defensive sectors, such as health care and technology, while avoiding lending to borrowers in industries reliant on commodities and heavy cyclicals. We think it is essential for investors to partner with top-tier private equity sponsors with decades of successful experience investing in the same industries.
A secondary market for private credit fund interests is emerging due to the growth of private credit managers and the enormous interest in the private debt space over the past several years. Given the current income dynamic of these investments, we think this market could develop significantly over the next several years, offering opportunities for large institutional investors seeking to diversify their portfolios.
Even at this late stage of the cycle, there is a case for an allocation to mezzanine debt in a private credit portfolio provided it meets our strict lending parameters. This can position the portfolio for value and yield opportunities in the coming phases of the cycle.
We see more opportunities in the U.S. than in Europe. The maturity of the U.S. market allows direct-lending managers to be highly selective and hand pick the very best deals for their portfolios. In turn, investors have access to better market dynamics and more conservative assets.
Risks to our outlook
In the current market, we have seen more aggressive structures typically found in the larger broadly syndicated loan market continue to creep into the upper middle private market, such as covenant-lite loans. Given the increased competition for middle market loans, we are also seeing credits being underwritten with weaker overall credit profiles. We believe these trends will continue until there is some sort of credit event that gives lenders pause.
From an industry perspective, the increased importance of scale will drive smaller managers to larger, more diversified platforms. Merger and acquisition activity will continue to grow in private debt as the costs to compete for deal flow and support the required infrastructure will make it challenging for these smaller managers.
Broad allocations to alternative, less liquid assets should be maintained in accordance with a portfolio’s long-term investment objectives.
Among a portfolio’s alternative exposure, capital currently reserved for, but not committed to, private equity is likely to be better rewarded on a riskadjusted basis in private credit for 2020 vintages.
While we continue to see select opportunities in mezzanine debt, in most cases we recommend that investors stay senior in the capital structure and increase their average credit quality given riskadjusted spreads. Senior mid-market private credit should outperform more junior, subordinated paper over the coming quarters given an expected uptick in default rates.
We like sourcing spread duration and security selection risk in private credit. The asset class provides clear access to manager skill as they leverage relationships in the origination process, improve credit selection through in-depth credit analysis and have room to negotiate favorable terms and bond structures.
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