We hear a lot about the rapid growth of private credit. How would you describe the market today?

The private credit market really started to take off post-financial crisis, when we saw the regulatory framework change for the banks, making their lending more selective, reducing liquidity and creating a funding gap that allowed alternative lenders like ourselves to step in.

Since then, private credit has grown and includes many sub-asset classes. For us, private credit covers commercial real estate lending, fund finance, private placements for corporates and infrastructure debt, but really we are talking about any financing by non-banks outside the public markets. 

Direct lending is by far the largest component of the market, but private credit covers everything from aviation finance to music royalties, mezzanine debt and special situations. Our focus in the investment-grade space is attractive to investors to complement their fixed income allocations as they look for a pick-up in returns compared with public markets.

Private credit is patient capital, and everything comes in cycles. There have been some headwinds in direct lending and in commercial real estate lending, but we see green shoots of recovery, especially in the latter area.

Should we be concerned about the risk of defaults going forward?

We have seen economies slow and interest rates rise, which caused real estate valuations to correct and highlighted some issues across portfolios.

Loans that were originated before 2022 will have benefited from a period when interest rates were at, or close to, zero percent. Those now coming up to refinancing will have a very different interest rate environment. As a result, there will be some stress, and perhaps even distress, in the market. However, generally speaking, managers across private credit have maintained underwriting discipline, particularly in the senior debt space.

As you move up the capital structure and take on more risk, we anticipate the headwinds to have greater impact, but for the most part we think the asset class is well-positioned from a defaults perspective.

What is your area of highest conviction? 

We take a holistic approach, so we speak to our macro team and colleagues in real estate equity and public credit to reach a house view on where we have the most conviction. Right now, investment-grade private credit is high conviction for us.

Fund finance is particularly appealing to investors because those loans usually have two- to three-year durations, which means you can get a 100-150 basis point uplift to the equivalent corporate bond market with short duration in an otherwise illiquid asset class.

Within fund finance, many deals are rated AA because the loan is secured against a fund’s investors’ commitments, generally without recourse to the actual underlying investments in the fund. The risk of default is incredibly low, which attracts investors.

Similarly, we have high conviction in commercial real estate lending. While this may seem counterintuitive, with real estate values correcting in 2022 to 2023, now is the best time to lend. We generally look to finance the best-in-class assets with particularly strong ESG and energy performance credentials.

There is certainly a polarisation in the market between those best-in-class assets and others that are maybe secondary or tertiary, and in certain cases the gap between these assets is growing. A lot of private credit or alternative lenders don’t have the same legacy books that the banks have and, in our own case, since we are focused on the investment-grade space, this does lead us towards the high-quality end of the market.

That brings me to ESG, which is important for us as a firm. ESG moved up the agenda during the covid-19 pandemic and is now a ‘given’ for our investors. We are incredibly focused on that as a lender, as are our peers. There is a lot of competition for those properties with strong energy performance credentials, as well as strong social and governance characteristics.

When it comes to private placements and infrastructure debt, we are seeing a lot of interest in infrastructure debt, particularly with regard to inflation-linked loans or renewables. In private placements, we see an increasing number of companies looking to refinance from the public markets. As with private credit more generally, this gives us the opportunity to offer bespoke loans that give investors greater downside protection. 

Where do you see the growth opportunity for the asset class?

The investor base is evolving. Defined benefit (DB) pension schemes moved into the investment-grade private credit space as they were attracted to the reliable and predictable cashflows and the illiquidity premium relative to the public markets, when compared with the same rated loans. But that world has changed, mainly due to rising interest 
rates, and many DB schemes are now in surplus and moving away from illiquid assets. Instead, we see huge appetite coming from insurers, who adhere to a slightly different regulatory framework but present significant opportunities.

We have a rich heritage in the insurance space, offering investors expertise in navigating the regulatory framework and reporting and rating methodologies. For insurers, these three ‘R’s’ are key in matching adjustment eligibility investment grade lending and are important for investors to consider when selecting a manager.

Another theme is the emergence of a credit secondaries market, which brings liquidity to an illiquid market. We all have to be careful what we wish for there, however, because by bringing liquidity to an illiquid market, there is a risk that we diminish some of what makes private credit attractive versus public markets.

We are seeing the emergence of defined contribution (DC) pension schemes as investors – we are in the early stages of this process but we see it as an area of growth across private credit in the coming years. Regulators need to ensure that personal pensions and/or individuals are properly protected. 

One such example of this is the Long-Term Asset Fund, a type of UK-authorised open-end fund designed to provide easier, simpler access for DC investors to long-term private markets investments, while providing some flexibility for investors wanting to buy and sell.

Finally, for our own part, we have a strong presence in Asia-Pacific and we are seeing growing borrower and investor appetite. There is a huge, relatively untapped investor base for private credit and a substantial amount of pension money available in Asia that could create a significant opportunity as the market gains a greater understanding of what private credit can offer. 

 

This Q&A has been taken from the Private Debt Investor - Future of Private Debt issue.