Private credit investing is growing to fill the void left by banks. In 1995, banks still controlled approximately 70% of middle-market lending. As priorities changed, that number gradually declined over the last 25 years. Lending regulations also tightened considerably after 2008. As a result, banks only accounted for about 10% of middle-market lending in 2018. By tapping into the markets abandoned by banks, private credit investors can obtain higher yields than bonds, more stability than stocks, and greater portfolio diversification.
Offering Higher Yields Than Bonds
As banks moved away from lending to small and medium-sized enterprises (SMEs), the risks and yields of corporate bonds declined. The financial crisis in 2008 caused a partial return to the tighter credit standards that prevailed in the decades following the Great Depression. As prosperity returned, we have also seen a return to the low bond yields of those decades. AAA-rated corporate bond yields fell below 3% for the first time since the 1950s at the beginning of 2020.
Higher yields are still available to private credit investors. Yields of around 7%-10% can be obtained on private loans to mid-sized companies. In emerging markets we are seeing yields between 10%-17% to companies with cash flow from operations and growing EBITDA. Even higher yields are possible when investing in distressed debt. While there is greater risk than in the public bond market, there are also higher returns.
Supplying More Stability Than Stocks
Many investors perceive private credit as too risky, yet private credit is inherently more stable than stocks in many ways. Firstly, private lending provides claims on a firm’s assets in the event of bankruptcy. Furthermore, companies seeking loans in private markets have less access to credit than firms that can issue bonds in public markets. As a result, there are fewer competing claims on assets. That can mean better opportunities for recovering funds when defaults occur. If there are no defaults or restructurings, then private loans simply offer higher yields. The combination of higher perceived risk and potentially lower actual risk gives private credit more stability than stocks.
Private loans provide a source of diversification for portfolios. Private credit has emerged as a distinct asset class, separate from stocks, investment-grade bonds, and even high-yield bonds. While there are some similarities with high-yield bonds, the variety of different firms seeking private credit makes it a much more diversified asset class. For example, high-yield bonds offer little exposure to the technology and real estate sectors. More importantly, adding private credit to a portfolio that only contains stocks and bonds can increase returns while reducing volatility.
Lower Liquidity Leads to Higher Returns
Private credit is generally much less liquid than public bond markets, which leads to higher long-term returns. According to research by Ibbotson, Chen, Kim, and Hu, liquidity has a large and statistically significant effect on stocks. Liquidity also has a substantial impact on debt. The ability to sell liquid assets quickly on the market provides benefits for investors, which they must pay for in the form of lower returns. As markets develop, they also tend to become more liquid. When that happens, asset prices rise. Today’s private credit investors can benefit from this process.
Due Diligence Makes a Difference
While the illiquidity of private credit creates the potential for higher returns, it also creates dangers for less experienced investors. Private credit markets were dominated by banks only a few decades ago, and successful private credit investing requires the same level of due diligence. At Ashton Global, we have extensive experience in many forms of private credit including revolving facilities and term loans to private companies, as well as trade finance and socially-responsible investments in developing markets.
Due diligence for private credit at Ashton Global involves a conference call and in-person meeting with management teams, and thorough background check on the principals, managers, and related entities. Next, we sensitize management’s financial projections versus our internal base and downside cases. We also use lawyers to verify all collateral, asset ownership, liens, etc as another layer of due diligence.
Our experienced risk management team mitigates the risks of fraud through a rigorous due diligence process. With our guidance, institutional investors and high-net-worth individuals can tap into the advantages of private credit markets while minimizing downside risk.
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