Private credit: a main street opportunity

Key takeaways

1. A growing market opportunity in private credit is leading wealth investors to consider new investment strategies and approaches to portfolio construction.
2. Private credit can be viewed as an extension of fixed income, but it is also a distinct asset class that offers diversification benefits in a total portfolio context.
3. As private credit investment capabilities become more mainstream, it is critical for investors to understand what they are buying and how those strategies and managers are differentiated from one another.

Demystifying private credit

After years of providing institutional capital solutions to investors, the private credit markets have begun to attract significant interest from wealth advisors. In fact, what was previously considered alternative and accessible only to the most sophisticated and professional investors is quickly becoming a mainstream opportunity.

What’s driving main street investors to private credit?

1. A growing market opportunity that is already bigger than you think - the private credit market is now over US$1.7 trillion (including US$400 billion of “dry powder” or liquid assets available for future use). The private credit market is now similar in size to the US broadly syndicated loan (US$1.3 trillion) and high yield markets (US$1.3 trillion).¹ We believe that the total private debt market could exceed US$3.5 trillion in the next 5y. (Exhibit 1)

2. A more accessible market providing better understanding of risks and opportunities - innovation in fund structures has grown beyond private funds and publicly traded Business Development Companies (BDCs) to include other vehicles such as interval funds and non-traded BDCs, which may offer fund features and liquidity profiles more closely aligned to the underlying assets. An increasing number of registered funds in the marketplace is increasing transparency as these SEC-regulated vehicles typically deliver more reporting and valuation transparency vs. traditional private funds.

3. Differentiated return drivers in private credit may complement traditional portfolios - wealth investors of all sizes are leveraging more risk analytics and technology to support portfolio design and construction, incorporating non-traditional assets while seeking to improve overall portfolio efficiency and transparency. (Exhibit 3)

Exhibit 1: We expect global private debt AUM to reach $3.5 trillion by year-end 2028
Private debt global assets under management (unrealized value and dry powder), and AUM forecasts

Role of private credit in a portfolio

1. Private credit as an extension of your credit portfolio
Credit strategies play an important role in portfolio construction due to asset characteristics such as structural seniority versus equity, and contractual coupon income as the primary driver of return. (Exhibit 2) Private credit can deliver those benefits and relatively low interest rate sensitivity versus traditional fixed income. As a result, private credit provides diversifying exposure to a conventional equity/bond mix, potentially leading to a more efficient overall portfolio (i.e. better expected return per unit of risk). (Exhibit 3)

2. Diversify with differentiated return drivers
Adding private credit expands the investible universe to include private middle market companies, which are typically smaller than public market peers and are critical drivers of economic growth in the US. As compensation for taking on illiquidity risk in smaller companies, investors can earn a yield premium typically driven by wider credit spreads versus public market peers, tighter loan documentation that helps protect lenders from adverse credit events, and origination fees that accrue to the investor rather than the investment bankers.

 As adoption of private credit into wealth portfolios grows, investors will become aware of a wider range of managers and capabilities. In the same way that “large cap value” and “small cap growth” are different categories in the equity market, there are significant differences across the private credit landscape that investors need to understand. Direct lending is the largest component of the private credit market today and represents ~46% of total private credit assets. Unsurprisingly, within direct lending we can further differentiate the market based on company size with lower, core, and upper middle market businesses offering a wide range of risk profiles. Other categories of private credit include mezzanine financing and distressed debt, which have a different risk/return profile then direct lending. (Exhibit 4)

Exhibit 2: History points to a yield premium in private credit

Considering an allocation to private credit

1. Funding an allocation: Private credit assets are primarily floating rate loans, making them most similar to broadly syndicated bank loans, and they are often compared with exposures to high yield bonds or structured credit (e.g. collateralized loan obligations). Outside of those exposures, fixed income is generally the most relevant exposure, though investors should consider what role their credit allocation needs to play in a total portfolio context.

Exhibit 3: Adding direct lending strategies to traditional stocks and bonds

2. Choosing an access point: One of the biggest barriers to entry among wealth investors remains accessibility. Recent innovation in fund structures has opened up new access points for individual investors. Evergreen structures like interval funds have gained significant traction based on an investor’s ability to subscribe to them like a traditional mutual fund on a daily basis.

Similar to interval funds, non-traded business development companies (BDCs) have also seen a rise in popularity over the past few years. This structure provides investors with an opportunity to access the private credit market through a registered vehicle that offers periodic liquidity. Additionally, BDCs have regulatory reporting and disclosure requirements like traditional mutual funds, making them more transparent than conventional private funds. Both interval funds and BDCs typically have lower investment minimums and investor eligibility requirements which make them more widely accessible to investors.

However, BDCs and other fund types often require subscription documents and offer a less frequent reported NAV which adds a layer of operational complexity. Technology and digital platforms are expanding to streamline operational processes for advisors, which should enable the continued growth across wealth channels. In our view, there is value in overcoming those operational challenges as private markets may provide a return on complexity.

Exhibit 4: The term “private debt” encompasses a wide range of investing strategies
Total private debt AUM, by strategy

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