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.
Turning 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.
Varadero 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.
Crestline 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.
