Private Credit: More than Just Direct Lending

By Aksia LLC, Featured Author

Key Points

We believe:

• The private credit asset class is virtually as diverse as the global economy.
• Institutional investors typically seek to invest across a range of private credit sectors to diversify their portfolios with the aim of improving risk-adjusted returns.
• Private credit can offer opportunities for income.
• Several sectors of the private credit asset class may offer compelling potential throughout the market cycle.
• Many private credit sectors offer an inflation buffer either through floating-rate coupons or through exposure to hard assets whose values tend to rise in inflationary environments.
• Private credit’s historic performance generally has been resilient.

Private credit is a big house, and the direct lending sector is only one room inside. Direct lenders predominantly provide loans to companies purchased by private equity funds (“sponsors"), but there is a larger universe of private credit opportunities beyond private equity dealmaking. Private credit finances transportation equipment, real estate, structured debt assets, royalty streams, supply chains, receivables, intellectual property, equipment leases, fleets of trucks, airplanes, ships, helicopters, river barges, and railcars. Private credit investments can be found on six of the seven continents (and Antarctica is probably not the best place to seek investment opportunities). It is virtually as diverse as the global economy.

Below, we lay out Aksia’s private credit “map” or the addressable market for the asset class: a framework of six sectors each containing a number of strategies.

Private Credit is More than Direct Lending

People are often surprised to hear that direct lending accounts for less than half of historic private credit capital raising and that US sponsor-focused direct lending accounted for less than 20% of total fundraising activity from 2018 to 2022.¹ The direct lending sector itself contains a variety of strategies and investors may gain diversity from differences in borrower size (e.g., upper middle market to lower middle market), geography (e.g., Europe), industry focus, and collateral types.

Institutional investors typically seek to diversify across a range of private credit sectors to diversify their portfolios with the aim of improving their risk-adjusted returns.

The table above illustrates what Aksia believes are the drivers of returns across different private credit sectors. Investors should not be surprised that the main driver is yield for most. However, private credit also offers the opportunity for capital gains over and above current income. For example, distressed debt investments might capture an outsized return when buying a loan trading at a discount that is later refinanced at par whereas special situations deals may include a lump sum payment at maturity, a prepayment fee or other enhancements like a revenue share or equity participation. Mezzanine investments can also generate some “equity upside” via attached equity warrants.

The table also shows what Aksia believes are the inflation environments and market conditions favorable to each. Most private credit sectors offer an inflation buffer either through floating-rate coupons or through exposure to hard assets whose values tend to rise in inflationary environments.

Most private credit investments should provide downside risk mitigation through senior lien positions and sound collateral.  A well-structured direct lending transaction should feature financial covenants along with other levers to protect investors upon unforeseen challenges and to help mitigate losses. Similarly, specialty finance transactions are often collateralized loans by a variety of asset types. Reporting tracks underlying collateral performance (typically referred to as “borrowing bases”), allowing lenders the ability to respond to worsening collateral by sweeping cashflows to repay loans and de-risk. Other specialty finance strategies seek to buy less correlated assets such as royalty streams—patients’ demand for critical pharmaceuticals generally should have limited correlation to the financial markets.

Private credit’s historic performance has been resilient. Based on Aksia’s proprietary returns database, as well as data from Preqin and Pitchbook,² the 2018 and 2019 direct lending fund vintages (direct loans mostly completed prior to the worst of the COVID-19 pandemic) reported median net IRRs of 7.6% and 8.6%, respectively as of April 2023.³ Specialty finance funds of those same vintages tend to have even higher median net IRRs of 9.6% and 11.2%, respectively, as of April 2023.⁴

Distressed and special situations private credit strategies offer investors the chance to capitalize on uncertainty. When banks and other traditional lenders pull back from lending, distressed and special situations managers tend to be hunting for new investments. Capital starved businesses can seek them out to provide essential financings. Based on the abovementioned data set, 2008 vintage distressed and special situations funds reported a net IRR to investors 16.1%.⁵ The 2009 vintage was not far behind with 13.8%.⁶ When the credit markets seize up, private credit managers can be well-situated to both offer financing and to extract favorable terms.

The hundreds of private credit investments covered by Aksia typically target net returns to investors ranging from 7% to 15%.⁷ We typically advise our institutional clients to build diversified “core and satellite” portfolios that target a variety of private credit sectors and underlying strategies. This portfolio construction approach often includes exposure to the large, scalable private credit opportunities like global direct lending and real asset/real estate debt deals, while adding a range of specialist transaction types, often targeting niche markets along with ones capitalizing on shifting market conditions.

Aksia’s Private Credit Target Returns Range

Source: Aksia

Conclusion

We believe that a diversified private credit portfolio can offer investors an opportunity for more stable returns and current yield through market cycles. Further, this approach can often complement an investor’s overall portfolio invested in equities, fixed income and other alternative investments through seeking to lower overall risk and provide income enhancement.

To learn more about the opportunity of the global private credit asset class, please reach out to your Calamos Investment Consultants at 888-571-2567 or email at investmentprofessionals@calamos.com.