Private credit has come of age in 2023 as institutional investors shift allocation models to increase diversification, pursue absolute returns and reduce market correlation.
Many US institutions, including pension plans, foundations, and endowments, are fully allocated to public and private equity markets, which benefited greatly from over a decade of low interest rates, cheap funding and attractive discounted cashflow valuation frameworks. Given the backdrop of high inflation, slowing economic and corporate growth outlooks, and global political uncertainty, however, debt yields now look increasingly attractive.
Public debt including high yield bonds, syndicated loans and sovereign emerging market debt currently earns unlevered, high single-digit returns. The ICE BofA High Yield Index, yielding 8.5 percent as of writing, is right in line with the 20-year S&P 500 average return. Within private credit, however, investors can earn returns several hundred basis points higher by originating well-covered, senior-secured loans across corporate, asset-based, real estate and other niche credit asset classes.
Opportunities across the private credit market are also large and extensive enough to accommodate a change in direction among institutional investors, with one investment bank recently reporting that private debt now accounts for more than 20 percent of total capital borrowed by leveraged companies, up from just 2 percent in 2012.
We are in the golden era of credit because the entire credit universe now earns substantially more due to the normalisation of rate policy. The 500-basis point increase in the Fed Funds Rate directly benefits credit investors on both an absolute and relative basis to equity. On a relative basis, the 5 percent increase in credit returns is directly coming from the equity paying for debt service out of its cashflow.
For opportunistic private credit investors, higher interest rates and tighter credit conditions should also lead to strong dislocation and distressed cycles in 2024, as a wall of maturities comes due. The opportunity set will span privately originated capital solutions and mutually beneficial restructurings, especially as floating-rate liabilities impact the most indebted borrowers. Many balance sheets carrying five-plus turns of leverage are simply less tenable in today’s environment.
Through the lens of leveraged loans, borrowers with more than 3x interest coverage typically have a long-term default rate of around 2 percent. When those coverage ratios fall below 2x, we see cumulative default rates hit double digits. Under current economic conditions, including rising cost of labour, those expenses become increasingly difficult to pass along to customers and end consumers.
Our expectation is that the annual and cumulative default rates over this cycle will be 5 percent and 10 percent respectively, potentially resulting in over $500 billion of distressed debt. This dynamic is compounded by recent troubles in the US regional banking system, which further underscore the need for private credit to bring fundamental stability and liquidity to commercial lending.
Private credit strategies spanning direct lending, asset-based lending and financing for equipment, transportation and commercial real estate benefit greatly from contractual income and principal repayment schedules, seniority in the capital structure and covenants providing downside protection. From this pack, ABL historically has the lowest default and highest recovery rates over a credit cycle, thanks in part to cautious underwriting and favourable debt-service coverage and loan-to-value ratios that sustain during periods of inflation.
The tight-knit relationships one typically sees between private lenders and borrowers, preferably combined with industry expertise, can enable more proactive and efficient approaches to detecting issues early on and renegotiating loan terms to mitigate defaults.
Putting this all together, we are in a golden era for credit that is poised to grow over time, regardless of broader economic volatility trends. Accordingly, we expect capital allocators to continue to increase their allocations substantially on a go-forward basis.
Bruce Richards is founder, chairman and chief executive officer of Marathon Asset Management, the New York-headquartered fund manager