Mainstream markets just don’t yield enough
Roughly a year into the COVID-19 pandemic, the economic outlook remains tepid, and investors have few places to turn for income. In the United States, the 10-year Treasury note yields a nominal 1%, while the 3-month T-bill yields only nine basis points (bps).¹ Negative rates elsewhere, along with tight credit spreads worldwide, have deprived global bond markets of their historical appeal. Meanwhile, low dividend payouts and high earnings multiples have reduced equity return expectations, too.
Negative-yielding debt sets a new world record: US$18 trillion
Source: FactSet, December 31, 2020. Figures in U.S. dollars.
When paired with the right partners, though, long-term investors allocating to private credit stand poised to enjoy higher yields, lower price volatility, and broader diversification benefits when compared with those who limit their portfolios to stocks, bonds, and bills. We examine the relative merits of investing in senior credit and junior credit, with an emphasis on direct lending to private equity-backed companies across North America’s middle market.
Private credit offers yield seekers a rare opportunity
While investors holding bonds and broadly syndicated bank loans can always decide to sell their positions in a highly liquid secondary market, direct lenders, or private credit investors, generally enter into long-term relationships with their borrowers. The arrangement affords private credit investors an opportunity to capture an illiquidity premium over yields of comparable quality bonds and bank loans. On September 30, 2020, the current yield differential between high-yield corporate bonds, for example, and private credit stood at roughly 2%. While the illiquidity premium associated with directly originated upper middle market loans has topped 250 basis points in recent years, we believe it resides closer to 150 bps in the current market, in light of today’s low absolute yields and tight credit spreads.² Within the broad category of private credit, two of its subcategories—senior credit and junior credit—offer investors different, complementary attributes.
Private credit’s yield premium provides lenders a comfortable cushion
Current yields, September 30, 2020 (%)
Source: Bank of Canada, Deutsche Bundesbank, Cliffwater, FactSet, Ministry of Finance (Japan), U.S. Treasury, September 30, 2020. See notes below for the list of asset class proxies.⁵
Senior credit for investors seeking capital preservation
Senior credit strategies aim to generate positive real yields by extending secured floating-rate loans directly to middle market companies. Loan financing has shifted from syndicated bank deals toward privately negotiated agreements directly between lenders and borrowers—club execution—representing a less efficient and, by extension, higher-yielding debt market. While the banking industry has been backing away from middle market lending for decades, the trend accelerated following more onerous regulatory capital requirements in the wake of the global financial crisis. For the five years ended in 2000, banks’ share of the loan market stood at 59%, with institutional non-bank investors claiming the residual; for the five years ended in 2019, direct lenders had gained the upper hand, as banks’ share of the loan market had dwindled to only 12%. The bankers’ retreat has created a clear opportunity for non-bank investors able and willing to step in and lend directly to businesses.³
The outlook for senior credit remains favorable. A record $2.5 trillion in private equity dry powder—capital committed but not yet deployed—points to a persistent need for financing to fund leveraged buyouts, add-on acquisitions, and dividend recapitalizations.⁴ With fewer commercial banks making loans to middle market companies, institutional investors with direct lending programs stand to benefit disproportionately. Relative to comparable debt issued by larger companies, middle market senior credit can offer an enviable combination of higher spreads, lower leverage, and stronger covenants—making it a strategy of choice for yield-seeking investors focused on capital preservation.
Junior credit for premium yields, plus upside potential
Sitting below senior credit in a company’s capital structure, junior credit is funded with flexible capital and can include second-lien loans, subordinated debt, and preferred stock with equity-linked upside. Interest can materialize as cash-pay coupons or through pay-in-kind flexibility, depending on the deal structure. Preferred equity with warrants or convertible features and call protection can result in attractive multiples on invested capital. While today’s high valuations plague buyers of most asset classes, large multiples can actually be an advantage to providers of junior credit. Within the middle market, sizable equity cushions below the junior capital tranche provide creditors with extra support, making the debt less susceptible to risk of impairment. Investors in junior credit of leading businesses with strong free cash flow generation, room for operational improvements, and multiple ways to create value can pursue an attractive mix of income and appreciation potential, a pairing difficult to find in today’s market.
Private credit calls for close relationships and specialized expertise
Institutional investors continue to covet private credit, a niche market segment that requires strong industry relationships, especially those with middle market private equity sponsors, many of whom help source private debt financing for their portfolio companies. Additionally, private credit investing demands the ability to properly evaluate complex custom transactions within a relatively compressed window of time. Since opportunities often surface out of a need to deploy debt capital promptly, private credit investors must assess a range of crucial factors fast, such as:
Ownership—How capable is the owner of the company in question?
Business—Is the company operating in a growing industry with favorable fundamentals?
Management—Do executive incentives and skills align with the interests of the investors?
Price—Do the valuation, financing, and structure of the transaction represent an appropriate expected risk-adjusted return?
Like any skill, distinguishing the most promising deals from those with weaker risk/return profiles requires repetition, and repetition requires access. Tapping into a steady, recurring flow of quality private credit investment opportunities from highly regarded private equity sponsors can be challenging, especially for the uninitiated investor. Many sponsors limit invitations to partners with proven resources that have helped secure prompt and reliable commitments. Now more than ever, direct lenders who have cultivated a strong network of deal-sourcing relationships and developed a discerning eye for asset selection are proving their worth. At a time when investment income has become scarce, long-term investors would be wise to lean into the attractive yields available in private credit.
1 U.S. Treasury, December 31, 2020. 2 Manulife Investment Management, December 31, 2020. 3 S&P, December 31, 2019. 4 Bain & Company, December 31, 2020. 5 Private credit (including junior): Cliffwater Direct Lending Index; private credit (senior only): Cliffwater Direct Lending Index: Senior Only; U.S. high-yield bonds: Bloomberg Barclays U.S. Corporate HY Index; U.S. corporate bonds: Bloomberg Barclays U.S. Corporate IG Index; U.S. core bonds: Bloomberg Barclays U.S. Agg Bond Index; U.S. Treasury notes: 10-year; Canadian government bonds: 10-year; short-term U.S. Treasury bills: Bloomberg Barclays U.S. Short Treasury Index; Japanese government bonds: 10-year; German government bonds: 10-year.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
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