Private credit investors weigh growing risks
Investors and consultants have raised concerns about growing risks for investors in private credit markets, as leading managers rush to deploy cash from the fast-expanding sector.
“Some [managers] are being very aggressive about the volume of capital they are raising and less selective in terms of deployment,” said Thibault Sandret, head of private debt research at bfinance in London, a consultant with a large number of family offices and institutional clients in the Asia Pacific.
“The volumes of capital being raised by certain players over the last two years, are making me a bit nervous. [Managers] are not going to be as careful about where they spend it,” Sandret said.
A large number of established alternatives managers – Apollo Global Management, Blackstone and Ares Management – have moved into the private credit sector in recent years, with many launching open-ended funds with quarterly liquidity. The sector historically was dominated by closed-ended funds in which investors faced long lock-up periods.
The reassurance of these big names and track records have been particularly effective in drawing APAC investors into the asset class in increasing numbers.
RELIANCE ON BIG NAMES
“The majority express a preference for semi-liquid open-ended private credit funds managed by established institutions with extensive track records. This inclination towards established institutions stems from a desire for stability in navigating the asset class,” said Sky Kwah, director of investment advisory of Raffles Family Office.
According to Sandret, the return of banks competing for deals favoured by these major managers means opportunities have become more crowded and have resulted in a risk of lower returns.
“These large private credit deals had become a lucrative segment for them, thanks to the retreat of competitors, particularly banks providing syndicated loans. But today that market is re-opening: competition from the banks creates tighter spreads and weaker investor protection [as funds must settle for weaker loan covenants to win deals],” he added.
And he questioned the effectiveness of APAC investors’ focus on large, established global managers. “Yes, there is often name recognition when you are raising capital from investors, especially HNWIs. But it may not be with the biggest names that you are getting the best risk-adjusted returns,” he said.
The retreat of banks from providing syndicated loans has its roots in the aftermath of the GFC, when new regulation on banks increased capital charges for loans that remained on their balance sheet, making syndicated loan markets more responsive to market cycles.
“Syndicated loans became an originate-to-distribute business model, and banks retreated from volatile markets, such as those of recent years, when fast-evaporating demand could leave them stuck with unsold loans on their balance sheets accruing high capital charges,” said Sandret.
Allocations to private credit have increased among rich individuals in APAC and beyond in recent years, attracting flows from sectors that have not performed as well, such as private equity.
Globally, private credit grew from 8.3% of fund searches by family offices in 2022 to 12.4% in 2023, according to a report published by Preqin on February 28.
Nearly three-quarters of investors (73%) reported the asset class exceeded their expectations, making it the alternative sector with which investors are most pleased. Investors are reallocating from other asset classes with which they have been less satisfied, as a result. “Family offices are … pivoting from challenged asset classes such as private equity and venture capital into other parts of alternatives,” the report noted.
RISING DEFAULT RISK
Private credit appealed to investors during the current interest rate tightening cycle since loans are typically issued with floating interest rates that track base rates, and also help to hedge inflation in portfolios.
However, higher borrowing costs have seen wider activity slow in private equity and other private markets, such as real estate and infrastructure, reducing the number and range of lending opportunities. Rising rates have also stirred concern among investors that borrowers may struggle to keep up repayments at higher levels.
“It's essential to acknowledge the potential vulnerabilities of private credit in a heightened interest rate stress environment. Fluctuations in rates can impact companies' free operating cash flows, potentially exposing private credit investments to increased risk and tighter covenant headroom,” said Kwah.
Meanwhile, the prevalence of individually negotiated, bilateral agreements between lender and borrower often results in greater difficulty for investors to evaluate the precise risk entailed in investments.
“Like all credit products, there is always a risk that the underwriting criteria does not capture all the risks, sometimes from information being provided from the borrower but also how strict the lender is in enforcing covenants, validating information,” said Andrew Sharrock, chief investment officer of Landmark Family Office.