Diversifying Your Fixed Income Portfolio With a Private Credit Allocation

April 20, 2022 |
3 minute read
|

Inflation, rising interest rates, inversion in the yield curve and the war in Ukraine combined to make 1Q22 a challenge for many asset classes and strategies. While there was the isolated shelter from the storm such as commodities in general and energy in particular, during the quarter conditions in the fixed income market were especially challenging, namely the -5.93 percent return for the Bloomberg Barclays U.S. Aggregate Bond Index (exacerbating the Aggregate’s one-year return of -4.15 percent).

Private credit is a category within the fixed income market that has generally shown resilience over the past year. While acknowledging the important role of central banks and government policy during the COVID-19 dislocation, we see good evidence that the characteristics of credit allow it to perform well in challenging environments. As evidence, risk-adjusted returns have been attractive and downside protection has generally served investors well.

Private credit can be defined as direct, non-bank lending to businesses seeking to raise capital for any number of purposes from PP&E to acquisitions and many others. In private credit, the investor can lend at more attractive terms than those typically found in public markets; the loan agreement can include covenants, collateralization and/or other terms that secure the loan, the debt is generally not traded and typically experiences less price volatility than what is observed in public markets.

At Commonfund Forum 2022, a panel of private credit managers discussed their businesses in a session entitled “Niche Strategies in Private Credit.” Because of private credit’s compelling characteristics, capital has flowed into the category in recent years; an asset class that currently has $1.2 trillion in capital is expected to double by 2026. Much of this capital has been going into senior secured lending strategies, effectively private credit “beta,” making niche strategies relatively more attractive on a forward-looking basis. The three Forum panelists’ comments provide insight into this segment of the market.

Maggie ArvedlundTurning Rock Partners is a corporate credit provider making structured capital investments into the lower-middle and middle-market in North America. As CEO Maggie Arvedlund explained, the firm looks to create its position in the capital structure by entering a deal at a discount that is influenced by both intrinsic value and current conditions, which underscores the firm’s strong value orientation. The firm focuses on companies with definable cash flows and solid assets on their balance sheet.

JLansky-250pxVaradero Capital, represented by co-founder and portfolio manager Jonah Lansky, follows an approach different from Turning Rock. It’s a non-corporate lender targeting specialty finance. The typical focus is lending to consumers and small businesses. Loans such as these can be a part of the asset-backed securities (ABS) market that Varadero Capital participates in. The firm emphasizes downside protection, structural enhancements and the safeguarding of principal.

DPhilipp-250pxCrestline Investors focuses on several private credit strategies, including portfolio solutions/fund finance. David Philipp, partner and senior portfolio manager, explained that the firm’s fund finance strategy makes loans to private equity funds that are collateralized by the private equity fund’s portfolio companies. The proceeds of the loans can be used by an individual portfolio company or one level up by the funds themselves. Philipp noted, “We tend to be somewhat special situations-driven as our cost of capital is generally expensive and funds want to borrow for a short period of time for something that is very specific and highly accretive.”

The core themes that emerged during the discussion were the diversification that the three firms represent in terms of their target markets and investment strategies. Similarly, all stress downside protection — “We focus on left-tail risk,” said Jonah Lansky — and a heavy emphasis on diligence. To the latter point, David Philipp observed that Crestline’s diligence period can take months and the firm’s team includes specialists with skills in private equity, private credit, secondary markets, valuations and restructuring.

Another shared theme: for these lenders, volatility creates opportunity. As Maggie Arvedlund said, “Volatility creates uncertainty … the owner/operator, sole proprietor businesses that we focus on have been through a fatiguing time. When business owners are wrestling with uncertainty, they don’t want to worry about capital on the balance sheet. That creates demand for us.”

Through changing investment environments, the fundamental rationale for private credit remains lower correlation to other asset classes; the potential for strong risk-adjusted returns, including higher yields/current income; less competition; better pricing; and better deal terms, including, in certain strategies, exposure to floating rate loans.

Those attributes are attractive in just about any economic, geopolitical or market environment. In times when volatility and uncertainty predominate, they mean that private credit may warrant investors’ close consideration.

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Vincent Kravec

Author

Vincent Kravec

Managing Director

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

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Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.