Private Credit from our perspective is a “big tent” that encompasses many alternative credit strategies. The sub-strategy of Private Credit that has seen the most focus in recent years is senior lending. This segment of the market has non-bank lenders providing loans to companies, in many cases owned by private equity sponsors, which are floating rate in nature, not traded on public markets like high yield bonds or broadly syndicated loans, and which are typically held to maturity by the lender. As some like to say, it’s a “storage business” not a “moving business.” Aside from senior lending, investors can also find private credit strategies that focus on lending to stressed or distressed borrowers, hybrid strategies that pivot between private lending and public credit markets depending on the relative attractiveness of the opportunity set, and many others.
At Commonfund, we find private credit interesting, in part because we can tap into the expertise of managers that have long experience in the market, and the wisdom and skill that come along with that experience. We work with managers that have weathered volatile and challenging environments like the COVID dislocation, the 2015/2016 energy sell-off, the U.S. ratings downgrade (2011) and the Great Financial Crisis. Focusing on managers with a robust track record allows us to assess that track record, observe how the loans they have made and the lender protections they have obtained have withstood challenging environments. In the current environment, we want to see managers with deep workout skills, the infrastructure to manage challenged assets, and the capabilities to drive improved outcomes.
Private Credit can achieve several objectives in a portfolio:
Depending on the sub-strategy, Private Credit can provide meaningful diversification, correlation benefits, and optionality to add value in various market backdrops.
Commonfund believes strongly in the benefits of diversification, and while exposure to floating rate strategies can provide a tailwind in a Fed tightening cycle to combat higher inflation, we wanted to find other ways to bring additional inflation protection characteristics into the private credit portfolio. We implemented aviation leasing as part of this effort. This has been compelling for several reasons including: the impact on the residual value of aircraft with higher input prices (raw materials and labor), the duopolistic nature of the industry (Boeing and Airbus) with significant visibility around production schedules, the exposure to quality counterparties on the leases, and the exposure to early-life narrow-body aircraft that are more energy efficient and less likely to be “parked” in a recession.
Music royalties is also a sector we like, and while we do have some indirect exposure to this strategy through a multi-strategy asset-based finance commitment, we don’t yet have a dedicated allocation. It is an interesting sector from the perspective of the predictability of cash flows and how these exposures can impact and provide diversification benefits to a credit portfolio. However, it does have some sensitivity to rates as ultimately it is a discounting exercise of future cash flows.
Despite the “denominator effect” and its impact on investors’ ability and willingness to make commitments in private markets, we are seeing a high degree of interest in private credit. In part this is from investors who are staying “on-schedule” with their private credit commitments. It is a difficult proposition to sit out the 2023 – 2024 vintages, which some suggest could be the best vintages for private credit funds of the last ten and next ten years, because of denominator effect issues. In speaking with market participants, we are hearing investors reducing, to a degree, their private equity or venture capital commitments in favor of maintaining their private credit commitments. Aside from those adjustments, we’re also seeing investors seeking to increase their exposure to private credit above previous targets, as well as new entrants coming to the space at what feels to be a very opportune time.
We are constantly talking to market participants, and we do see private credit strategies that focus on impact. That said, we focus on putting together well-diversified Private Credit portfolios that seek to achieve our return objective. From an implementation perspective, we believe we need to find “impact” programs that solve for all of these: risk/return/impact. The risk end of it can be particularly challenging. For example, if we were to commit to a lending strategy focused on solar, we need to consider: “What is our “look-through” exposure to geopolitical risk? Where are the raw materials sourced? Would the equity you are lending to be negatively impacted by elevated trade barriers or trade embargoes between China and the Western world? If the strategy benefits from government subsidies, is there a risk that if those subsidies are discontinued, and that the strategy will no longer achieve its objective?” When we consider local impact, we maintain our focus on lender protections: “How comfortable is a manager foreclosing on the borrower in the event of default?” This can be a difficult proposition from a social perspective at the local level. Other considerations include: “How tight are the loan covenants? What is the track record in the event of a covenant breach? What is the historical recovery given default?” When speaking of par lending strategies, getting back par + accrued interest generally gets you the “market” return, and maximizing outcomes in a credit cycle is a key driver of alpha.
We have been actively building a database of diverse managers since 2016. We cast a wide net and have many conversations, relying on Commonfund relationships, conferences, panel participation, reverse inquiry, outbound proprietary research, and databases, and today, in our most recently fully-committed closed-end private credit fund, more than 16 percent of manager commitments are diverse. Importantly, we believe this is an outcome of having many conversations with market participants as we seek to assemble a diversified portfolio of strategies that we believe can achieve our risk/return goals and isn’t a result of us targeting a particular diverse outcome.
Commonfund OCIO is on the road meeting with institutions to discuss the topics above and more each year. Interested in being a part of the conversation? If you are interested in attending a regional roundtable in your area, please complete the form with your details. A member of our team will reach out to you with dates and locations of where we will be next.