Hand with chalk is drawing Risk and reward balance scale on the chalkboard

Financial conditions are tightening. Money supply growth is plummeting in Canada and contracting in the U.S. Surveys of senior loan officers indicate that lending standards have tightened to levels normally associated with recessions. Not surprisingly, business bankruptcies are climbing. Meanwhile, lending interest rates have shot up to heights not seen in over two decades.

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In this environment, private credit funds (also known as private debt) that provide direct lending to small and medium-sized businesses offer an emerging opportunity for advisors and their clients.

However, the unique characteristics and illiquid nature of private credit investing demands a thoughtful approach. Here are five guidelines for evaluating the opportunities in this asset class.

  1. Assess fund risk first

Private credit funds can be categorized into four types:

  • capital preservation strategies designed to provide reliable income (e.g., unleveraged senior secured loan funds);
  • subordinated strategies that provide financing further down the capital structure with a commensurate jump in both yield and risk;
  • specialty and alternative credit opportunity funds that can vary across the risk/return spectrum; and
  • higher-risk distressed, opportunistic and venture debt lending.

Regardless of the category, every fund’s risk profile is unique, so due diligence is required. Key factors to consider are the market capitalization, number and sector/geographic diversification of borrowers; seniority of the loans in the capital structure; terms (particularly the proportion of payment-in-kind loans whereby interest is added to the principal balance of the loan instead of being paid in cash) and covenants; loan maturities and interest rates; credit metrics of portfolio companies including any loan markdowns; and the nature of the collateral if the focus is specialty lending (e.g., receivables, inventory, equipment or intellectual property).

Critically, some funds allow leverage at the fund level so this can add a vital dimension of risk to evaluate. Leverage can magnify returns in positive scenarios but materially deepens losses when loans default.

  1. Consider only seasoned managers with strong multi-fund track records

A recent study of 448 private debt funds covering the vintage years 1986 to 2018 found evidence of manager skill in this asset class. Managers with top-quartile performance in a previous fund had a 35% probability of delivering top-quartile performance in their next fund.

Conversely, managers with bottom-quartile performance had a 39% chance of remaining in the lowest quartile with their next fund.

There is an important caveat to these results: They apply only when the prior fund is mature and approaching or at full investment. When the prior fund is in its early stages of investment, caution is in order in evaluating results.

Overall, higher relative returns in a prior fund were associated with higher returns in the next fund.

Unlike private equity funds where outsized returns on a single company can offset several losing investments, credit managers deliver excess returns by avoiding losses. Hence, due diligence needs to clearly identify a manager’s differentiated approach to loan origination, stringent underwriting methodology, strong monitoring and workout capabilities when a loan defaults, and capital base that allows broad diversification.

  1. Develop a cautious entry plan

As of March 31, the current yield of the Cliffwater Direct Lending Index, an asset-weighted index of approximately 13,000 directly originated middle-market loans, was an attractive 10.95%. However, loan defaults are expected to rise as the impact of this tightening cycle takes full effect, and, hence, returns will be eroded by credit losses. Credit losses have averaged 0.9% per annum over the past ten years but spiked to 3.3% in 2020 and 1.8% in 2017 because of the Covid-19 shutdowns and the aftermath of the oil slump, respectively.

With the divergence today in forecast economic conditions (ranging from soft landing to mild recession to hard landing), advisors should consider a more cautious entry plan into this asset class. Diversifying into several funds over the next two to three years is one such approach. Similarly, starting first with more conservative funds focused on capital preservation may be in order.

  1. Size with total credit risk in mind

Many pension plans consider private credit funds as a component in their overall credit allocations that include corporate and high-yield bonds as well as real estate and infrastructure debt. Their allocations to private credit are therefore judicious. According to the Pension Investment Association of Canada, their members had a median 5.4% of their portfolios allocated to private debt funds in 2022. Notably, this allocation increased from 3.7% in 2021.

  1. Allocate for tax efficiency

Unlike private equity funds, which principally generate capital gains, private credit funds mostly deliver taxable interest income. Therefore, asset location within a household can make a material difference in after-tax return realization.

Allocations should start with low-margin family members or family trusts with low-margin beneficiaries, registered plans, or corporations with substantial expenses or non-capital loss carryforwards.

Private credit funds are an emerging opportunity for advisors and their clients, but their complexities and today’s economic uncertainty demand a risk-conscious approach.

Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions.