Heading into 2025, historically low spreads on some higher-yielding credit instruments meant investors were not well positioned for recent tariff-related turbulence. At the end of 2024, the option-adjusted spread (OAS) on US HY bonds stood at 287 basis points (bps), in the bottom decile of historical observations. As a result, while the backup in spreads in recent weeks felt dramatic, it still leaves the current OAS (409 bps) below its historical median. A similar trend is evident in loans. The discount margin on BB-rated loans has widened by approximately 40 bps in 2025, but the current 297-bp spread is only around the 45th percentile of historical observations.

Investors considering increasing allocations to these assets should recognize spreads could go significantly higher if the economy enters recession. While the Global Financial Crisis may be an extreme level for comparison (HY spreads reached nearly 2,000 bps), during the past three recessions HY spreads averaged around 800 bps, around double today’s level. Another consideration is whether current pricing suggests HY bonds can keep pace with a comparable stock/bond mix. Our data suggest that buying HY bonds around current spreads (in the second quartile) has often resulted in underperformance relative to a stock/bond mix. Conversely, HY bonds have typically outperformed when spreads rise to the top quartile (around 585 bps or higher). Investors may be better off waiting for spreads to reach these higher levels before increasing allocations.

While the macro environment remains uncertain, there are positive arguments to be made in favor of US HY bonds and loans. Entering what may be a period of subdued growth, many HY issuers are in a position of relative strength. Rising revenue and earnings have allowed companies to gradually deleverage in recent years, and metrics like interest coverage ratios have shown steady improvement. Notably, today’s HY index consists of higher-quality borrowers than historically has been the case, which could provide a buffer if conditions worsen. Currently, ~53% of the HY index carries at least one BB rating, an 8 percentage point increase from a decade ago.

HY bonds and loans may also benefit from investors attracted to their higher coupons. The current HY bond index yield of 8.4% is around 170 bps above its average over the past decade. While broadly syndicated loan yields—currently around 9.0%—may also look enticing, we caution that this reflects lower average credit quality. Additionally, these instruments may see coupons decline if, as expected, the Federal Reserve resumes its rate-cutting cycle in 2025.

Given the uncertainty surrounding tariff-related volatility and concerns over foreign demand for US assets, investors should hold off on adding HY and loan exposure. Also, certain pockets within liquid credit already appear more attractive. One example is CLO mezzanine debt, which currently offers a discount margin of around 775 bps (equivalent to around a 11.5% yield). Historically, this asset class has suffered lower defaults than comparably rated HY bonds, though its lower liquidity can result in higher mark-to-market volatility. Due to the dispersion in underlying CLO fundamentals, we believe this asset class is best accessed via skilled managers.

In summary, HY bonds and loans have sold off in recent weeks, but from historically expensive levels. We recommend waiting for further clarity on the macro outlook or further pricing improvements before adding exposure to assets like HY bonds and loans. When conditions improve, investors contemplating adding to credit allocations should also consider CLO debt, which is currently more reasonably priced but may still face spread widening if tariff-related volatility escalates. Meanwhile, investors should maintain allocations to high-quality sovereign bonds, which should continue to provide critical portfolio diversification and stability amid ongoing macro uncertainty

Wade O’Brien, Managing Director, Capital Markets Research

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Specialty finance investments can be additive to a private credit portfolio. This asset class helps to diversify away from corporate lending to individual businesses and is broadly uncorrelated with equity markets. As a world within a world, specialty finance offers a wide range of underlying asset types and potential return targets. It allows investors to tailor the potential liquidity and duration when selecting a fund.

The Growth of Specialty Finance and Role of Alternative Credit Investors

As the amount of assets committed to private credit has grown, renewed attention is being paid to specialty finance. Prior to the 2007–09 Global Financial Crisis (GFC), the specialty finance market was a smaller, less prominent segment of the financial market. Traditional banks dominated lending activities, and non-bank financial institutions (NBFIs) played a relatively minor role. Specialty finance funds, meanwhile, have stepped in to address the financing needs of these NBFIs, resulting in nearly 10x growth in assets of these types of funds since the throws of the GFC (Figure 1) from $28.0 billion in 2008 to $275.8 billion in 2023.

Various factors have contributed to specialty finance’s growth, including tighter bank regulations and stricter capital requirements following the GFC. These rules in part came out of the Dodd-Frank legislation in the United States and the Basel III frameworks established as part of the Basel Accords in Europe. Banks incur risk-based capital charges against the specialty finance lending they do, which has direct impacts on the profitability of certain business lines. The onerous nature of this capital treatment has curtailed lending by banks, and in the cases where banks do engage in these activities, it has typically been with the most pristine businesses with proven track records, leaving newer or more complex borrowers with limited options to obtain financing.

This gap in the demand for borrowing and the supply of financing from banks has been addressed by the specialty finance market, which itself seeks non-traditional sources of financing. Private credit firms focused on the specialty finance space have demonstrated a willingness and ability to work with complex or underbanked segments of the market. These underbanked parts of the market are expected to grow as banks face further strain, including regulatory capital needs. In the United States especially—depending on regulatory approval—the application of the Basel III “endgame” would drive growth in this area. To get in front of this potential supply, specialty finance investors have in many cases been expanding their direct relationships with borrowers, including regional and community banks in the United States.

For US taxable investors in general, we expect that the returns from specialty finance funds to be characterized as ordinary income, and many have commensurate (and sometimes onerous) tax implications. For that reason, these investments might be more suited to non-taxable entities in the United States and non-US entities with friendly tax treatments.

Opportunities, Risks, and Advice for Investors in Specialty Finance

Specialty finance investing offers the potential for compelling risk-adjusted returns. Attractive characteristics of these investments are 1) the cash flowing nature of the underlying assets and 2) the downside protection often created through structuring. There is potential in the current market for higher investment returns from both higher base rates and wider spreads to compensate for the complexity of the assets or their structures.

Non-bank lenders, shadow banks, and financial technology (fintech) businesses have developed in recent years to address a varied set of opportunities.

Consumer and Small Business Lending

One area targeting finance companies in particular is lending against a pool of financial assets. The underlying loans can be made to consumers or small businesses, and this business of lending to lenders is sometimes called re-discount lending. This area has seen growth with the rise of fintech businesses, which help to streamline application, credit selection, and funding processes for consumer and small business financing.

A hallmark of this type of investing is the ring fencing of risk—to protect the collateral from the risk of bankruptcy at the loan originator, the specialty finance manager will lend against a pool of assets that is kept in a separate, bankruptcy-remote special purpose vehicle (SPV). In the event that there were problems with the borrower, the lending specialty finance fund can simply stop funding new loans or other financial assets, thereby stopping the creation of new risks while servicing and running down the book of business in the SPV. It is possible for the loan originator to file for bankruptcy and the specialty finance fund manager to take no losses as 1) the manager, not the loan originator, is exposed to the pool of assets, thereby allowing the pool to be transferred and serviced elsewhere; 2) the existing pool of loans might have been amortizing and reducing the fund’s cost basis; and 3) the existing pool of credits might still have the ability to repay their principal and possibly interest.

Expected returns can vary depending on the credit quality of the underlying investments as well as the seniority of the tranche retained by the fund. Benefits of such funds include diversification away from individual credit risks, as the portfolios tend to include pools of loans or other financial assets. Potential investors should be sure to understand the nature of the underlying assets and beware a concentration of risk in any single risk factor.

Asset and Equipment Leasing

Asset and equipment leasing involves the ownership of a pool of assets, such as transportation assets (e.g., railcars, aircraft engines, shipping containers), yellow metal equipment (i.e., construction and agricultural equipment), or restaurant equipment. As in a fixed income investment, the investor collects cash flows, but they are often in the form of lease payments tied to contracts on the assets and equipment. There is also opportunity to provide financing to companies looking to purchase such equipment.

Expected returns can vary based on the structure and duration of the leases offered as well as the growth stage of the lessee. Investors should take note of the expertise of the specialty finance manager as it pertains to 1) the assets being leased or financed and 2) the ability to structure customized leases that take into account the needs of the lessee.

Litigation Finance

Litigation finance is where investors fund plaintiffs or law firms to cover legal costs, receiving a portion of any monetary settlement if the case is successful. Expected returns are attractive, with internal rates of return (IRRs) for some strategies exceeding 20% and 1.5x multiples on invested capital at the portfolio level. However, individual cases have binary outcomes, with either full recovery or total loss of capital.

Aside from the potential for attractive returns, given the uncorrelated nature of case outcomes to traditional capital markets, investors can achieve diversification benefits for their portfolio. Additionally, there is a positive social aspect to consider, as litigation finance often enables access to justice for those who might not afford it otherwise. However, investors should be aware of potential regulatory changes, adverse selection by law firms, and duration risk. Targeting experienced, institutional-quality managers is recommended.

For those preferring a less binary risk-return profile, managers providing loans to law firms or investing in specialized opportunities may offer more downside protection, while still providing attractive risk-adjusted and uncorrelated returns.

Insurance-Linked Securities

Insurance-linked securities (ILS) are financial instruments where investors take on risk from insured natural catastrophes (e.g., hurricanes and earthquakes) and man-made events (i.e., marine, energy, and cyber incidents). They provide interest income from insurance premiums and principal repayment if no material financial loss occurs. Common types include catastrophe bonds, industry loss warranties, collateralized reinsurance, and collateralized retrocession.

Most ILS are exposed to a narrow definition of natural catastrophe risk: loss due to residential property damage caused by natural disasters. Therefore, diversification is the main attraction of investing in ILS, as the returns of the asset class are uncorrelated to traditional capital markets. Additional highlights of ILS include access to specialized insurance markets, capital efficiency, the potential for attractive risk-adjusted returns, and inflation protection due to their floating-rate nature.

However, portfolio implementation and benchmarking can be challenging. Careful manager selection is crucial, considering factors such as capital reserving techniques and climate change approaches. Investors should be mindful of market cycles and potential headline risks, and a long-term commitment is recommended.

Royalties (Life Sciences and Music)

Royalties in life sciences and music offer exposure to revenue streams from intellectual property. In life sciences, royalties come from pharmaceutical products, medical devices, and biotechnology innovations, paid to original developers or patent holders based on sales or usage. In music, royalties are earned from musical compositions, recordings, and performances, paid to songwriters, artists, and producers whenever their work is played, streamed, or sold.

Benefits of investing in royalty strategies include diversification (returns are uncorrelated to traditional financial assets), steady income streams (royalties provide a consistent and often predictable income stream, as they are tied to the ongoing sales or usage of the underlying intellectual property), and the asset class is often viewed as an inflation hedge, as payments typically increase with the rising cost of goods and services.

Considerations of the asset class include potential regulatory changes (particularly in life sciences) that could impact returns, market demand as the value of royalties is highly dependent on the continued demand for the underlying product or work, intellectual property disputes, and the illiquid nature of royalties.

In some cases, there is a need to assess both loan originators and underlying customers. An investment manager pursuing such investments must underwrite the underwriter and analyze the credit box/profile to which they lend. This analysis on occasion requires expertise in some narrow areas in the market whether that is understanding the mechanics of mass tort lawsuits or having the relationships with lessors of transportation assets and structuring appropriate leasing deals. Look for specialty finance managers with platforms that offer advantages in sourcing investments. While each case is unique, these advantages might be conferred through the breadth of the origination team, the quality of borrower relationships and repeat nature of business, as well as exclusivity or flow arrangements with fintech companies.

Concluding Thoughts

With specialty finance funds, we can generally expect IRRs in a range of mid-single-digit percentages to high-teen percentages, with the difference in returns being a function of use of leverage, age of the borrower, and tenor of the deals. In addition, there is an unknowable element at play in cases, such as litigation finance that might rely on juries’ decisions (Figure 2). A review of specialty finance funds across vintages in the Cambridge Associates database revealed a mean IRR of 11.8%. ¹

Specialty finance investing has added layers of complexity relative to other forms of private credit investing. As such, these investments are typically not a core investment in a private credit allocation but rather a satellite or complement to core direct lending exposure. The funds tend to be in typical private equity fund structures in which capital is committed and drawn down across various vintages. In those cases, the funds have investment periods ranging from two years to four years and fund lives of six years to ten years, although the full term of many funds tends to reside in the six- to eight-year zone. Even within these fund lives, many of the transactions are shorter duration in nature relative to private equity deals, for example. As such there is room for recycling of capital during the investment period, which can help drive the fund’s multiple on invested capital. However, the evergreen fund structure has become more popular in recent years, offering limited partners (LPs) flexibility with respect to continuing to invest as well as timing of monetizations and exits.

While the return streams of specialty finance investments often maintain low correlation to general credit and equity indexes, there is the potential for market volatility to impact these investments. Interest rate changes, for example, can have impacts on the cost of financing for the borrowers but also for specialty finance lenders. In some cases, market volatility can impact the value of the underlying pools of assets in these transactions, which has ripple effects on the loan-to-value (LTV) metrics monitored and provide guardrails around risk taking for some specialty finance investors.

Investing in specialty finance funds with their varied sources of returns can help to diversify your portfolio while preserving capital and should help create more stability of cash flows. In this way, specialty finance investing can provide an effective complement to a broad private credit allocation.

Adam Perez, Managing Director, Credit Investments

Joseph Tolen, Senior Investment Director, Credit Investments

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.

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Liquid Credit Returns Should Be Lower in 2025

Wade O’Brien, Managing Director, Capital Markets Research

Following solid gains in 2024, US liquid credit returns will be lower in 2025, given lower credit spreads and expected Fed easing. The flipside is that credit fundamentals remain sound and there are pockets where investors can find attractive risk-adjusted returns.

US high-yield bonds returned roughly 9% year-to-date through November 30 and US investment-grade credit bonds generated around 4%. Returns were boosted by falling credit spreads; through November 30 US high-yield and investment-grade index spreads had fallen by 58 bps and 21 bps, respectively. The decline in Treasury yields further benefited returns, with respective yields at 7.14% and 5.05%.

Even if investors in 2025 receive coupon-like returns, this would still be higher than recent averages, given the low interest rate environment that prevailed prior to the pandemic. For example, the ten-year AACR on US high-yield bonds was just 5.1% as of November 30. Returns next year could receive a lift if spreads compress further or if the Fed cuts rates faster than expected, though we would note spreads look expensive on a historical basis and in recent weeks the amount of expected Fed easing in 2025 has been pared back.

Either way, returns should be supported by improving fundamentals. Earnings growth was inflecting upward for both high-yield and investment-grade borrowers as 2024 drew to a close, and borrowers with floating rate debt should continue to see interest coverage ratios improve given falling short-term rates.

Looking across liquid credit markets, we are neutral between fixed and floating rate. Additional rate cuts could boost values for the former, but the latter will serve as a hedge against inflationary pressures. Across all types of liquid credit, we do not think it is an opportune time to stretch for yields, as spreads for most assets are in the bottom quartile, or even decile, of historical readings. While being mindful of duration, collateralized loan obligation debt offers a spread pickup with little give up in terms of credit quality or liquidity.

Insurance-Linked Securities Should Deliver Attractive Returns in 2025

Joseph Tolen, Senior Investment Director, Credit Investments

The insurance-linked securities (ILS) market continues to be attractive and should deliver strong returns in 2025. The demand for additional catastrophe coverage from insurance companies has kept the market firm, providing sufficient cushion for reinsurers and ILS managers to absorb risk. This is evidenced by managers achieving impressive returns in both 2023 and 2024 despite a notable rise in severe storms in the US Midwest, multiple significant hurricanes making landfall, and flooding in Europe. The sustained hard insurance market, combined with the uncorrelated nature and diversification benefits of investing in ILS, make 2025 an attractive opportunity for investors.

Several factors have supported the insurance market, which has improved ILS pricing and resulted in more favorable terms and conditions for investors. Premium increases following Hurricane Ian and balance sheet losses on the back of a particularly challenging year for traditional assets in 2022 created a capital shortage for reinsurers, limiting their ability to provide coverage for insurance companies. Conversely, demand for protection from insurance companies has sharply increased due to high rates of inflation in recent years and the need for broader coverage, largely related to climate change.

The supply/demand imbalance is set to continue into 2025. Additional supply will be available from reinsurers and ILS managers following two strong years of performance, but this is expected to be offset by continued demand for coverage from insurance companies, particularly on the back of hurricanes Helene and Milton. These factors will keep the insurance market firm, leading to more attractive pricing for investors and giving them additional cushion to absorb losses, even if 2025 sees higher-than-average catastrophe events.

When considering opportunities, terms and conditions will be crucial to performance success. We favor managers that are meticulous in portfolio construction and appropriately invest in line with their stated risk/return profiles regarding attachment points and where they sit in the capital stack, perils, trigger mechanisms, geographies, and so on. Doing so will help mitigate exposure to risks associated with climate change, put investors in the best position to absorb losses from events, and help maximize returns.

Currencies Should Become a Tailwind for Emerging Markets Local Bonds in 2025

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

The currency component of EM local currency bond performance has frequently been the dominant driver of the asset class. This is perhaps unsurprising when one considers it has exhibited nearly twice the volatility of the local currency performance. In four out of the past five calendar years, including 2024, the currency return has been a detractor from the total return for a USD-based investor, which is of course explained to a large extent by the strong performance of the dollar over this time period. While the currency return may not exceed the fixed income return in 2025, we think it is likely to cease being a headwind and ultimately become a tailwind.

The J.P. Morgan GBI-EM Global Diversified Index currently yields 6.30%. This is at the 34th percentile of its history, so in terms of return drivers, it looks as though the carry of the index will be somewhat below average in 2025. Despite this more moderate yield, there is still scope for the index to deliver some price appreciation next year. Inflation in emerging markets has remained contained after the post-COVID spike. Therefore, with real yields still somewhat elevated, there is scope for EM central banks to ease rates should growth conditions necessitate. Further, if DM bonds yields decline, EM bonds yields, which typically trade with a beta to those of developed markets, should also move somewhat lower.

Our EMD-weighted currency index has declined in recent months, now sitting 14% below its median real valuation versus the dollar. We anticipate this valuation gap will narrow somewhat next year. First, from the USD perspective, the currency remains richly valued against substantially all peers. Though we remain sensitive to the risk of further dollar appreciation given, in particular, the spectre of tariffs being placed on trade with the US, we expect the dollar to eventually weaken as the Fed continues to ease policy, narrowing interest rate differentials. Furthermore, the growth differential between emerging and developed markets looks set to widen as we move into 2025, which may support the risk appetite for EM assets. Any additional policy easing from China would reinforce such a dynamic. Naturally, there are risks to this view, such as a material slowdown in global growth or a pickup in global inflation. However, our expectations are for a more favorable environment for EM currencies in 2025.

Direct Lending Returns Should Decline in 2025

Wade O’Brien, Managing Director, Capital Markets Research

Direct lending funds are on track to generate strong returns in 2024, returning 9% year-to-date through September 30. Returns should decline in 2025 as central banks continue cutting benchmark rates and competition among lenders lowers credit spreads. Still, spreads will remain above those available in public credit, and rising deal volumes will create more opportunity for investors to put capital to work.

Benchmark yields have moved lower after the Fed’s recent rate cuts and are expected to continue declining over the course of 2025. Direct lending spreads are also falling and are now around SOFR+ 525 compared to around 370 bps for broadly syndicated loans (BSLs). Spreads should continue to decline in 2025, given competition from the BSL market for larger deals and as direct lending funds are eager to deploy more than $250 billion in dry powder.

There is some good news for investors. Credit fundamentals, which have been under pressure for some borrowers, should improve in 2025 as rates decline. This will be especially helpful for smaller firms, which have seen slower revenue growth than larger peers. Default rates on private loans should start to recede as debt servicing ability improves.

Deal volumes have picked up in recent quarters and this trend should continue in 2025. Low interest rates are improving deal economics for PE sponsors, which in some cases are under pressure from investors to deploy capital. Greater supply could serve to offset some of the downward pressure on spreads from growing competition among lenders.

Weighing these dynamics, investors in private lending funds should continue to earn higher returns in 2025 than available from public equivalents and should see more capital put to work. Lower middle-market funds may suffer from less spread compression than large peers, which tend to face competition from BSLs, though investors should carefully screen managers as not all small companies will see fundamentals improve.

Liability Management Transactions Should Accelerate in 2025

Frank Fama, Head of Global Credit Investment Group

With the Fed transitioning to a rate-cutting cycle and inflation trending to target, recession fears have largely abated. However, with the dearth of M&A activity and weak IPO market, PE sponsors are finding it difficult to exit investments. Sponsors are faced with an aging portfolio and a number of problems. Many of these leveraged buyouts (LBOs) were financed in the broadly syndicated loan market in 2021 before the rate increase cycle and after the disruption of COVID-19. Lenders agreed to provide high leverage due to elevated valuations and low interest rates, and credit protection provisions were extremely weak. Now PE sponsors have overleveraged companies with maturing debt in need of a recapitalization solution and companies in need of growth capital to take advantage of attractive opportunities.

Credit opportunities managers will work with sponsors to take advantage of the excesses of the BSL market to structure investments that may prime existing lenders and lend new money at mid-teens rates. Known as liability management, the transactions can take different forms, but they all take advantage of provisions in the credit agreement that allow for the creation of new debt, to the detriment of existing lenders. Skilled managers are able to accumulate a position at a discount and structure and lead a transaction that results in at par or near par recovery for their debt and create a new debt security that is senior and secured by the most valuable collateral. Executing the strategy well requires active management and strong industry relationships. At first, sponsors viewed the transactions as excessively aggressive, but they are coming to view the solution as effective in managing their stressed LBOs and activity is expected to accelerate in 2025.

PE managers are holding investments longer, which is creating pressure to continue supporting companies, either because the company has too much debt or the company needs growth capital. Credit opportunities managers will partner with PE managers to take advantage of weak creditor protections in loan documents to provide capital that is senior and at higher yields relative to the existing BSL lenders.

US Specialty Finance Transaction Volumes Should Increase in 2025

Adam Perez, Managing Director, Credit Investments

With US consumer non-housing debt at nearly $5 trillion and growing, the opportunity set for specialty finance managers to fund non-bank lenders is expanding. In addition, specialty finance funds are poised to engage in larger significant risk transfer (SRT) transactions with banks, driven by the need for banks to align their balance sheets with the Basel III Endgame requirements. These factors will increase US specialty finance deal volumes in 2025.

Declining policy rates and avoiding a global recession in 2025 should entice US consumer borrowing further next year. As traditional banks face regulatory constraints and capital requirements, non-bank lenders are stepping in to fill the gap. This shift is creating a robust pipeline of investment opportunities for specialty finance funds, which can provide the necessary capital to these non-bank entities and benefit from a sustained demand for alternative lending transactions.

Moreover, the Basel III Endgame, the latest set of rules from the Basel Committee on Banking Supervision, which aims to fortify the management of risk within the banking sector, is pushing banks to offload riskier assets from their balance sheets. Like specialty finance lending, SRT is another element in the trend of reduction in bank balance sheet risk. This regulatory environment is conducive to the growth of SRT transactions, a mechanism whereby a third party agrees to assume certain credit risks from a bank, deleveraging the bank’s balance sheet and thus providing the bank with regulatory relief. US bank regulator proposals for alignment with the Basel III Endgame portend higher capital charges and are an important factor contributing to the growth of these deals in the United States. In addition, our expectation that policy rates will fall will likely reduce net interest margins, putting further pressure on banks as they seek profitability to right size balance sheets through SRTs. As banks strive to align with these rules, SRT deal volume will increase in 2025.

Figure Notes

Spreads Look Expensive for Many Credit Assets
Asset classes represented by: Bloomberg US Corporate Investment Grade Bond Index (US IG), Bloomberg Pan-European Aggregate Corporate Bond Index (Euro IG), J.P. Morgan CLOIE BBB Index (CLO BBB), J.P. Morgan CLOIE BB Index (CLO BB), Bloomberg US Corporate High Yield Bond Index (US HY), Bloomberg Pan-European High Yield Index (Euro HY), and Credit Suisse Leveraged Loan Index (US LL). Observation periods begin June 30, 1989, for US IG, January 31, 1992, for US LL, January 31, 1994, for US HY, August 31, 2000, for Euro HY & Euro IG, and December 31, 2011, for CLO BBB & CLO BB.

Demand for Coverage at All-Time Highs, Evidenced by Catastrophe Bonds Outstanding
Data for 2024 are through November 30.

Direct Lending Spreads Have Steadily Declined
Three-month rolling averages for first lien term loans. Spreads are to the Secured Overnight Financing Rate (SOFR). EBITDA $100M+ data begin September 30, 2021.

Default Rates Remain Low, But Distressed Exchanges (Including Liability Management Transactions) Have Been Increasing
The Default Rate is calculated by dividing the number of issuers that defaulted in the last 12 months by the total number of issuers.

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.

The post 2025 Outlook: Credit Markets appeared first on Cambridge Associates.

Aaron Costello, Regional Head for Asia, and Vivian Gan, Associate Investment Director, Capital Markets Research

With the global economy showing signs of cooling and Chinese economic momentum remaining weak, the outlook for Asian markets is increasingly mixed. Certain markets have been more resilient, such as India, where domestic growth is still robust, and Taiwan, which has benefitted from the global rally in semiconductor and artificial intelligence (AI)–related stocks. However, elevated valuations in these segments pose a concern for investors, prompting a reassessment of opportunities elsewhere. In the current environment, a rotation towards markets that may be more defensive and where shifts in market dynamics are supportive of longer-term prospects is warranted. In this edition of Asia Insights, we highlight:

• Within Asia Public Equities, there is a growing emphasis on shareholder returns and a rise in the number of companies increasing dividend payouts and initiating share buybacks. This trend comes amid a market rotation towards high dividend–yielding companies, as investors seek stable income returns given rising uncertainty and overvaluations in certain segments of the market.
• In Asia Private Credit, capital has rotated away from China and towards developed markets such as Australia and South Korea, while India also remains a destination for capital. Broadly, the Asia private credit market remains underpenetrated and is less crowded but poised for growth, presenting an interesting opportunity for investors to gain a diversified exposure.
• India Venture Capital (VC) is also starting to look more attractive today given a favourable macroeconomic backdrop, an improving start-up and manager landscapes, and a broadening of exit channels. In contrast to India public markets, which have run up and appear frothy, India VC activity has cooled alongside global VC markets. As a result, India VC valuations are moderating, making now a more opportune time for investors considering access.
• Across China Private Investments, fundraising activity remains frozen given uncertainty over geopolitical tensions and pending US investment restrictions. However, deal-level opportunities still exist in certain segments of the market, particularly for buyouts where the current macro environment is conducive for market consolidation and control opportunities.

Asian Public Equities: A New Era for Shareholder Returns

Wilson Chen, Managing Director, Public Equities

In Asia, we have seen an increased emphasis on shareholder returns and a notable rise in the number of companies initiating share buybacks and increasing dividend payouts. Japan, driven by regulatory changes and increased shareholder activism, has led this shift. Reforms introduced by the Tokyo Stock Exchange in January 2023 have put pressure on Japanese companies that trade below book value to take action to narrow their valuation discount, largely through increasing dividends and conducting shares repurchases. Such measures have helped to boost Japanese companies’ return-on-equity and supported upward stock price revaluations, creating positive tailwinds for the market. The small-cap segment could see greater benefits from reforms, given wider valuation discounts.

In South Korea and China, similar efforts are now being observed. South Korea’s ‘Corporate Value-up Program’ seeks to improve capital efficiency and equity valuations of firms through the voluntary disclosure of plans to enhance shareholder value. In China, more firms are responding to regulatory calls to increase dividends and share buybacks and others are re-listing on more favourable exchanges or spinning off units to unlock value and boost investor confidence.

From a total return perspective, dividends have always played a crucial role, although their importance has been magnified in markets such as China, which has seen weaker earnings growth and depressed valuation multiples. In the current environment, investors have rewarded companies able to generate high, stable income returns, a rotation that is reflected in the performance of the MSCI AC Asia ex Japan High Dividend Yield Index, which has outperformed its parent index by 4.2 percentage points (ppts) year-to-date and 9.4 ppts over the trailing one year. The trend of increased emphasis on shareholder returns in Asia is positive for investors and may also be a more defensive strategy given rising uncertainty and overvaluations in certain segments of the market, such as semiconductors and AI-related stocks.

Asia Private Credit: Growing Momentum for Asia ex China Strategies

Vijay Padmanabhan, Managing Director, Credit Investments

Private credit in Asia (including Japan and Australia) remains an underpenetrated market relative to the size of the region’s economy and demand for capital. Private credit and other forms of non-bank credit represent approximately 20% of the total Asia credit market, as compared to 65% in North America. Meanwhile, fundraising by Asia-based private credit funds amounted to just 5% of total capital raised by global private credit funds in the trailing five years ending 2023.

Fundraising activity slowed sharply in 2023, with lacklustre activity in part due to ongoing weakness in China’s property market. Many pan-Asian general partners had been overweight China prior to its real estate crisis, and the performance of these strategies, as well as that of dedicated China funds, has continued to struggle since.

Outside of China, however, the opportunity set remains robust. Managers are increasingly pivoting to developed Asia markets such as Australia and South Korea, which are credit-friendly jurisdictions in which banks are retrenching and high-quality collateral is available. The presence of higher sponsor activity in these markets creates space for sponsor-backed lending opportunities, while credit opportunities in sectors such as real estate are also rising given a trend of tightening liquidity from traditional lenders. Across emerging Asia, India is a bright spot for managers given its resilient economic growth outlook and improving credit regulations and credit landscape. India private credit had predominantly leaned towards distressed credit due to its legacy non-performing asset challenges and, more recently, in the aftermath of its NBFC (non-bank financial company) liquidity crisis. However, the strategies have since broadened to include performing credits in the underserved, midmarket segment, and solution capital to businesses for share buybacks and growth or acquisition financing.

Lower penetration and competition today create a compelling environment for Asia private credit strategies, as these allow for deals to be executed at better terms, pricing, and covenants. Overall, the market is poised for growth and presents an interesting opportunity for investors seeking to gain a diversified exposure across both developed and emerging Asian credit markets.

India Private Investments: The Growing Attractiveness of India Venture Capital

Vish Ramaswami, Head of Asia-Pacific Private Investments and Sharad Todi, Senior Investment Director, Private Equity

Amid a mixed economic outlook for Asia, India has stood out for its resilient economic growth. As a result, India public equity markets have run up and appear frothy, making some investors cautious about entering the market. In contrast, India’s VC market is cooling in terms of fundraising and deal activity alongside a shakeout in global VC markets, and valuations have moderated, particularly for later-stage VC. Given India’s long-term growth potential and favourable government policies, today may be a more attractive entry point for India VC in our view.

Dedicated India VC fundraising totaled only $1.8B in 2023, down sharply from more than $10B in 2022, and remains small compared to total global VC fundraising at $201B. Yet, India VC is benefitting from an improving start-up landscape in terms of the quality of founders, business models, and technology. The Indian government has spearheaded the creation of a digital public infrastructure or ‘India stack’, which has been widely adopted by start-ups to create disruptive new business models and tools. Consumer focused start-ups have moved away from cash-guzzling business models and towards profitable, sustainable growth. Enterprise technology start-ups are setting global standards in sectors such as software-as-a-service and financial technology.

Meanwhile, the manager pool has matured significantly. Progressing from a generalist mindset, managers are taking distinct market positions and have developed capabilities beyond simply sourcing deals to enhancing value and risk management. While India VC fund distributions have lagged their global counterparts, this may improve going forward as India’s capital markets broaden. In addition to initial public offerings, new exit routes are emerging, including merger & acquisitions deals and sales to financial sponsors and large family offices.

India VC also provides a different sector exposure compared to Indian public markets, which may be more reflective of the future growth drivers of the Indian economy. Given a cooling of the market, now may be a better time for investors to refresh their assessment of India VC for potential opportunities to gain access.

Chinese Private Investments: Frozen Fundraising, but Deal-Level Opportunities Remain

Vish Ramaswami, Head of Asia-Pacific Private Investments, Scolet Ma, Senior Investment Director, Private Equity, and Linlin Zeng, Investment Director, Private Equity

Fundraising for Chinese private equity and venture capital (PE/VC) slowed further in first half 2024 from the already depressed levels seen in 2023. Total capital raised by USD-denominated Chinese PE/VC funds fell to $1.0 billion in first half 2024, down from $16.9 billion in 2023 and $30.1 billion in 2022. Muted levels of fundraising largely reflect uncertainty over geopolitical tensions and pending US investment restrictions on China, although investor sentiments have also been buffeted by a weaker outlook for China’s economic growth and public markets.

Slowing economic momentum and a poor environment for exits have also weighed on VC and growth equity deal activity and exits, particularly for sectors, such as semiconductors and AI, that are subject to pending US investment restrictions. However, pockets of opportunity remain. Healthcare and biotech, for instance, have seen continued foreign investor activity even in the face of the proposed US BIOSECURE Act ² .  A rise in the development of innovative drugs and devices from China has spurred an increase in out-licensing activities and acquisitions by global pharmaceutical companies. Across other sectors, opportunities are similarly present, particularly given some recent downward valuation adjustments. Limited partners that possess a longer investment horizon (i.e., beyond a typical PE/VC fund life of ten years) and have the patience and ability to tolerate uncertainty may be able to take on certain co-investments to capitalize on current attractive valuations.

Meanwhile, Chinese buyout activity picked up in first half 2024, with 19 deals completed as compared to 31 in all of 2023. The current macro environment bodes well for market consolidation and control opportunities. Weaker economic growth in China has created more willing sellers across both domestic founders, as well as multinationals looking to divest from China. Valuation gaps between buyers and sellers have narrowed, and lower borrowing costs in China imply availability of leverage. Although the Chinese buyout market remains less proven, the current environment is favourable in supporting the building out of such strategies.

Derek Yam also contributed to this publication.

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.
2. The pending US BIOSECURE Act identifies five Chinese biotech companies that would be prohibited from obtaining US government contracts or deriving revenue from US companies and agencies that receive US government funding. The proposed guidelines do not impose restrictions on US PE/VC investments into Chinese biotech.

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The Advantages of Private Fund Investments

Benchmarked Return Potential

Private markets can add considerable value to family portfolios. Yet, when it comes to evaluating the performance potential of direct versus fund investments, the landscape differs significantly. The figure shows how private investment funds—as measured by Cambridge Associates (CA) benchmarks—have outperformed their public market equivalents over the past 20 years. It is worth noting that these benchmark returns are net of all fees, demonstrating the strong return potential of PI funds despite higher associated costs.

Although CA uses proprietary asset class benchmarks for private investments, standardized public benchmarks for direct investments do not exist. The bespoke nature and complexity of directs often requires investors and their investment managers to instead rely more heavily on their own qualitative assessments and judgments related to the intrinsic value of the asset.

Greater Geographic Reach

Families who focus only on a local market or region may miss a large part of the investment universe. Investors relying solely on a domestic portfolio risk becoming too concentrated while also forgoing opportunities to invest in leading companies domiciled in foreign markets. The broader the investment options, the higher the bar is raised. What’s more, investment talent is everywhere. We believe PI fund managers that specialize in specific markets, rather than having a global focus, are often better positioned to outperform. For example, a family with an operating business in Europe may seek to further globalize their investment exposure by seeking US-focused fund opportunities. Often, a fund-specific strategy is designed to complement a direct portfolio, augmenting the “in-house” resources of the family office.

Expanded Sector Allocations

Similarly, it can be difficult to source direct investment opportunities outside of the specific sector where a family has built their wealth and networks. And if deals are sourced, it can be challenging to develop the know-how required to be an effective investment partner. Expertise in one sector may not translate to expertise in another. For example, it would be difficult for a family with a background in software to leverage their knowledge and capabilities in an industrial strategy requiring large capital investment and manufacturing knowledge—or vice versa. Yet, both sectors should be considered as part of a family’s diverse investment opportunity set. PI fund investments can serve as a conduit to expand a family’s investable universe beyond sectors familiar to them. Relationships with general partners (GPs) can also provide access to professionals and CEOs outside of the family’s typical investment network, which can have a strategic benefit to other businesses in the portfolio.

Opportunities Across Various Stages

Unlike directs, PI funds offer families the opportunity to balance allocations across the PI spectrum to help manage asset class–specific risk. For example, the risks and returns of an early-stage venture opportunity are different from those in a mega-cap buyout strategy. While it is possible to invest across different asset classes and life cycle stages with direct investments, it typically requires managing a larger number of individual investments compared to fund investing. PI funds invest in companies at various stages of their life cycle, frequently specializing within a certain range of business development. Fund investing is also more capital efficient for diversification, especially for families with a smaller PI budget. Having multiple fund investments that target different deal stages can help reduce the impact of any one investment performing poorly. It also has the potential to provide differentiated sources of return and cash flow profiles.

Opportunities Across Different Deal Sizes and Co-investments

Often, large- or mega-cap direct deals—which can range from $10 billion to more than $200 billion—can be challenging for families to secure with participation dependent on the size and scale of the investors involved. Most direct deals tend to be focused on small- and mid-market segments. Through PI funds, families who may otherwise be left out can allocate to a diverse range of market caps, including small-, mid-, and large-cap investments. This can help improve the stability of portfolio returns and enhance their protection against downside risk. Additionally, PI funds offer professional management, diversification, and access to exclusive investment opportunities that might not be available through direct deals alone.

Co-investments provided by a GP to its limited partners (LPs) offer another pathway for families to engage with investment opportunities that might otherwise be inaccessible. They allow families to invest alongside a fund in specific deals, often with no or substantially reduced management fees or carried interest compared to what would typically apply to fund investments. This may enhance the potential returns on those investments. For families of wealth, co-investments represent a compelling way to gain more direct exposure to high-quality opportunities, while leveraging the expertise and due diligence capabilities of the fund managers. This approach can not only broaden the investment horizon but further align the interests of the investor and the fund manager, helping foster partnerships that could lead to other strategic investment opportunities. Investors should keep in mind that the most attractive co-investment opportunities offered by PI fund managers often parallel a manager’s specific experience and expertise, providing direct exposure in areas outside a family’s traditional skill set and business networks.

Different Generational Factors

Many direct investors got their start as entrepreneurs and grew into experienced business owners. They often leverage the skills honed from growing and running their personal businesses into being active, effective direct investors. However, this can make business and wealth succession planning challenging if the inheriting generation of family members does not share the same interest or abilities as the controlling generation. By contrast, fund investments are more institutional and transactional by nature, and do not require family members to preside over them in the same way. They can be easier to leave to beneficiaries and are suited to long-term investors focused on building a family legacy. PI fund opportunities can also provide a means for working with innovative investment ideas—from artificial intelligence to life sciences and music royalties. This can be a way of further engaging families with members across multiple generations and areas of interest.

Key Operational Differences

Direct investing and private fund investing can both be complex—but in different ways. It can be easy for families to underestimate the work involved with holding a directs portfolio. Direct investments sometimes require investors to sit on a board, provide operating advice, or may require extensive “in-house” capabilities to be dedicated to making an operation successful. Generally speaking, the more challenging the market environment and/or business conditions, the greater the time commitment. While fund investments require investment operational support, such as negotiating and executing LP agreements and managing capital calls and distributions, the operational burden they put on investors tends to be more consistent and—more often than not—significantly lighter.

Potential Challenges of Private Fund Investments

Skill Set Requirements

Whereas direct investments are typically more “hands-on,” a different kind of expertise is usually required to be successful in PI funds. The development and execution of fund strategies demands strategic insight, comprehensive due diligence on fund managers and underlying assets, careful risk management through diversification and hedging, and a deep understanding of fund structures and performance metrics. In many cases, industry knowledge and negotiation experience can give families an edge. To remain aligned with their broader investment goals, families should look for experienced investment managers in building a private fund portfolio.

Important Risk Variables

Blind pool risk is a principal factor pertaining to private funds. Families considering fund investments should remember that they do not have control over how the fund allocates capital. As a result, it is important to recognize that fund investments also often come with a high degree of illiquidity risk.

Fee Considerations

Private fund investors pay higher fees relative to other strategies. Historical returns should be considered when determining how they fit into a family’s broader portfolio, keeping in mind that top-tier PI fund performance may result in additional fees over the long term.

The Family Advantage

In our experience, families of wealth are often viewed as preferred strategic LPs by fund managers. While many PI fund managers can be hard to access, families have certain competitive advantages such as bringing a variety of operating backgrounds that are viewed favorably by fund managers. In addition, some managers appreciate that families can have less complex or formalized governance structures relative to institutional investors, helping with faster decision making through more immediate access to the decision maker(s). Many GPs also appreciate and identify with families who have an entrepreneurial background, allowing them to speak the same language of business ownership and development.

New Horizons

Incorporating a private fund portfolio alongside direct investments presents family investors with a strategic opportunity to augment their private market allocations, enhancing the potential for higher returns and greater diversification. However, skilled implementation is key, given the significant variance in returns within the private funds industry, coupled with its inherent illiquidity and other associated risks. To navigate these complexities, families should align their PI funds approach with their long-term financial objectives and desired level of risk tolerance. This alignment, combined with rigorous due diligence in manager selection, can greatly influence the outcome of their investments. Furthermore, disciplined management of the PI fund program—emphasizing vintage year diversification, maintaining adequate liquidity, and robust risk management—is crucial. By adhering to these principles, families can help create a resilient and high-performing PI fund portfolio that complements their direct holdings and successfully broadens their investment horizons.

Learn more about our Private Client Practice.

Elisabeth Lind, Managing Director, Private Client Practice

Sheetal Zundel, Senior Director, Private Practice

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.
2. The pending US BIOSECURE Act identifies five Chinese biotech companies that would be prohibited from obtaining US government contracts or deriving revenue from US companies and agencies that receive US government funding. The proposed guidelines do not impose restrictions on US PE/VC investments into Chinese biotech.

The post Unlocking New Opportunities for Family Investors Through Private Funds appeared first on Cambridge Associates.

What Is Private Credit?

Private credit investments are non-publicly traded investments provided by non-bank entities that fund private businesses. These investments encompass a wide range of strategies, including senior debt, subordinated capital, credit opportunities, distressed credit, and specialty finance, each with distinct features. At a high level, private credit consists of two distinct categories—lending and opportunistic (Figure 1).

Private credit strategies offer higher yields than traditional fixed income, with low correlations to both liquid corporate/municipal bonds and equity markets. In addition, private credit involves bespoke terms and structures that can offer ongoing cash yield and charges fees on invested rather than committed capital. Both elements help to mitigate a portfolio’s private investment J-curve impact. ³

Lending Strategies

Lending strategies offer money to borrowers for periods ranging from short to medium term, usually between three and five years. These loans often come with variable interest rates that can change over time. These strategies can be particularly appealing when the loans are for shorter periods and the lender has a priority claim on the borrower’s assets in case of default. Furthermore, many lending funds have provided attractive returns that are not closely linked to changes in interest rates—through self-liquidating investments that are designed to pay themselves off within a three-year period. In 2022, for example, these strategies generated strong positive returns, while liquid high-quality bonds (e.g., US government, corporate, municipal, mortgage) were all down more than 10%.

Private lending strategies feature privately negotiated, senior structured debt and traditionally generate a 8%–10% net unlevered returns per annum. The deals usually include contractual payments, high-quality collateral, enforceable covenants, and bankruptcy remote structures to control and disburse cash from interest payments and fees. Based on our experience, lending strategy managers can currently achieve 10%–12% net ⁴ unlevered returns, benefiting from elevated base rates and reduced competition from traditional bank institutions.

Opportunistic Strategies

Opportunistic credit investments employ higher return and higher risk strategies by providing companies with a broader set of capital solutions relative to lending-only strategies. These funds fall between each end of the risk spectrum—from traditional direct lending to control-oriented distressed. Credit opportunity and specialty finance funds invest in instruments such as secondary market bonds and loans, directly originated loans with warrants, and structured equity solutions. These funds typically target net returns in the 12%–15% per annum range. We believe they have the potential to deliver even higher returns during periods of market stress when traditional capital sources are less widely available. For example, many opportunistic credit funds preserved capital with positive returns from interest and fees in 2022, offsetting modest marked-to-market losses amid broader interest rate uncertainty.

Combining Lending and Opportunistic

Investors can also create a blend of lending and opportunistic private credit approaches with the potential to target net returns more than 12% per annum. In many cases, we believe a blended private credit program can provide investor a balanced source of returns, with current income received sooner and the opportunity for higher returning assets over medium- to long-duration periods. In these balanced programs, the distributions and return of capital from the lending strategies can also be used to fund capital calls for longer lock-up, opportunistic credit funds with longer investment periods and fund life.

Current Opportunities for Private Investors

The current investment environment presents a unique set of private credit opportunities for families and private wealth investors. Traditional banks have become more cautious about lending due to mixed economic forecasts and interest rate uncertainty. This caution is partly because some borrowers, especially in commercial real estate and corporate debt, are facing difficulties due to higher interest costs, particularly with floating rate loans. Some of these borrowers are finding it harder to refinance their debts at reasonable costs and struggling to sell off loans without incurring significant losses. Consequently, banks are reserving more funds to cover potential losses and are being very careful about issuing new loans, leading to reduced loan activity and less money available for borrowers. As a result, private credit funds have emerged as a critical source of financing, especially for mid-sized companies that are often overlooked by larger financial institutions. These funds are stepping in to fill the gap, providing much-needed capital in a tighter lending environment.

Second, in a market characterized by volatility and ambiguity, private credit offers a relatively stable investment option due to its secured nature and structured returns. Engaging in direct lending opportunities can allow for more customized deal structuring, providing both protection and flexibility. This can include negotiating stronger covenant protections or opting for asset-based lending to further secure investments. Investors may also want to explore opportunities in distressed debt markets. Economic downturns and market dislocations can create attractive entry points for investors with the expertise to navigate these complex situations, potentially leading to outsized returns as markets recover.

Last, it’s crucial for private investors and wealthy families to partner with experienced fund managers who not only have a proven track record in private credit but also possess deep sectoral expertise and the ability to conduct thorough due diligence. We believe partnering with an investment advisor with deep private credit research capability is instrumental in uncovering hidden gems and avoiding pitfalls in this nuanced space.

Understanding Key Risks

While private credit offers attractive benefits, it is important to be aware of its inherent risks. These risks include: illiquidity, constrained upside potential compared to private equity, manager selection, and tax inefficiency.

Depending on the strategy, private credit investments can involve capital lock-ups of three to ten years. Although slightly more liquid than other private investments, private credit investors need to be prepared to commit for the long term. What’s more, unlike the high-growth potential of private equity, private credit strategies often come with fixed returns—or return levels in which the upside is capped. While this can result in more stable returns with lower risk relative to other private investments, it represents a ceiling on how much a strategy can earn.

As with all private market investments, performance dispersion in private credit is wide (Figure 2). In some cases, steady returns might mask underlying challenges, including borrowers that have limited credit histories. We believe success in private credit investing comes from partnering with managers that have a proven track record, expertise in assessing credit risk, and a history of recovering investments. Selecting top-tier managers is essential for tapping into the full potential of private credit and earning an illiquidity premium.

Lastly, tax inefficiency poses a notable challenge for private and family investors in private credit. This issue arises because the interest income generated from private credit investments is often taxed at higher ordinary income rates, rather than the lower capital gains rates applicable to some other types of investments. This can significantly reduce the net returns that investors receive, especially for those in higher tax brackets. The complexity of the investment structures within private credit can also further complicate tax matters, requiring careful planning and management to meet the tax obligation. Understanding and navigating these tax implications can help maximize the efficiency and overall returns of private credit investments (see “Managing Tax Implications”).

Implementation: Things to Consider

To take advantage of attractive yield opportunities available in private credit, family and private investors should carefully consider several key implementation factors (Figure 3). First, liquidity needs are an important consideration, given the illiquid nature of many private credit investments, which may not be easily sold or converted to cash. The longer commitments required of some private credit investments make them more suitable to investors with a longer-term outlook that have a clearly defined target yield. Determining this target requires a close assessment of risk tolerance, as higher yields often come with higher risks.

Diversification is another key aspect of private credit implementation. Investors should consider diversifying their private credit portfolios across sectors that demonstrate resilience and growth potential, such as technology, healthcare, and renewable energy. A diversified approach can help spread risk across various sectors and credit qualities while capitalizing on emerging trends.

Robust due diligence is also imperative. Understanding the borrower’s ability to meet its debt obligations is paramount to mitigating default risks. Market conditions continually influence the availability of opportunities and the risk/return profile of private credit investments. Staying mindful of regulatory and tax policy changes is also important, as these can impact investment structures, compliance requirements, and overall returns.

When implementing private credit strategies, private investors and wealthy families often have a flexibility advantage. They can allocate more nimbly than other large investors, such as pensions or endowments, and are thus well positioned to take advantage of the current robust opportunity set. Flexible asset class definitions and target ranges can likewise allow them to allocate more opportunistically. For instance, credit opportunity funds that target higher returning assets can be sourced from traditional private investment allocations. But private investors and wealthy families can also consider a wider range of capital sources. They can, for example, position lending strategies within a portfolio as part of a fixed income or diversifier allocation, helping to smooth returns and provide protection in adverse market environments. For investors building new private growth sleeves, private credit can provide another option for generating risk-managed alpha.

Giving Private Credit its Due

Private credit investments have experienced a rapid evolution over the past decade. In fact, the private credit landscape has changed so much that investors that last explored it ten or more years ago may not recognize it today. Market conditions have helped to shape what may be a particularly auspicious cycle for the asset class. Higher interest rates and changing credit market dynamics have created attractive opportunities for private investors and wealthy families—but proper due diligence and implementation is essential. Allocations to private credit can be additive to overall portfolio positioning, serving as a complimentary source of growth and income generation along with strong downside protection. Ultimately, a customized approach to private credit that accounts for liquidity and tax challenges may be the best path for investors seeking a consistent income source that is less correlated to traditional fixed income and equity markets.

Buck Reynolds, Senior Investment Director, Private Client Practice

Wilbur Kim, Partner, Private Client Practice

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.
2. The pending US BIOSECURE Act identifies five Chinese biotech companies that would be prohibited from obtaining US government contracts or deriving revenue from US companies and agencies that receive US government funding. The proposed guidelines do not impose restrictions on US PE/VC investments into Chinese biotech.
3. A J-curve is an early period characterized by negative returns and cash flows, as investments are initially made and develop over time before they are in a position to be sold.
4. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.

The post The Private Credit Playbook: Understanding Opportunities for Family Investors appeared first on Cambridge Associates.

Why Private Credit?

The private credit asset class benefits from several characteristics that we believe are attractive to investors’ portfolios. The asset class has a contractual maturity date, often benefits from collateral, and is senior to the equity in the capital structure. These attributes provide compelling downside protection and a shorter duration relative to private equity (PE) and venture capital (VC).

Private credit has historically outperformed public leveraged finance asset classes such as BSL and high-yield bonds. As a private investment, the asset class exhibits less volatility than the publicly traded markets. While public and private credit marks will be driven by credit quality, public markets also include an element of supply/demand (market technical) that can cause mark-to-market price volatility. Depending on credit quality, private credit spreads tend to be 200 basis points (bps) to 600 bps higher than public markets (Figure 2).

Direct lending loans are floating rate, which have limited interest rate risk and help to protect a portfolio from rising rates. Loans will typically be structured with an interest rate floor, which will ensure a minimum level of income. Most strategies will distribute interest income quarterly, and, with an average life of three to four years, principal is returned at a significantly faster rate than private equity strategies. Additionally, with a contractual maturity date, private credit funds have shorter lives than other private investment strategies.

Relative to public markets, private credit strategies offer investors stronger alignment of interest. In the public markets, whether high-yield or BSL, underwriting banks have an originate-and-distribute model. In this model, the underwriting bank will view the borrower as their client, not the investor or holder of the loan. The motivation for the bank as intermediary is to obtain the best deal for the borrower that will clear the market. In private credit markets, the general partner (GP) is often the originator of the loan and the manager of the risk. The GP views the limited partner (LP) as its client, and its objective is to get the best deal possible for the fund.

Private credit strategies, particularly direct lending, benefit from downside protection through a number of contractual provisions. Financial maintenance covenants provide an early warning to deteriorating borrower performance, allowing for lender intervention and the ability to work with the company to influence an improvement plan. Lending on a first-lien senior-secured basis means that the direct lending loan is secured by assets of the company. In the event of a restructuring, private credit’s position in the capital structure means that it will receive a recovery before the equity. If the equity is worth anything greater than zero, then the direct lending loan will receive all its money back plus a return.

Private credit includes a diverse array of strategies allowing investors to build a portfolio of complimentary strategies. The section below reviews the sub-asset classes in more detail, but we believe that the diverse strategies available in private credit allow an investor to construct a portfolio that will be less correlated to equity markets and can produce stable, attractive returns.

Sub-asset Class Review

Figure 3 depicts how private credit strategies offer a range of return targets and fund lives.

Senior Debt

Senior debt, or direct lending, refers to funds that lend money to performing companies on a first lien senior secured basis. The loans will be used for a variety of purposes, including financing leveraged buyouts and acquisitions, funding growth, or repaying existing debt. The company may be owned by a private equity firm (sponsor-backed) or a public or privately owned company (non-sponsor-backed). Managers will tend to focus on company size, with lower middle market defined as companies with $10 million to $50 million of EBITDA; core middle market as companies with $35 million to $100 million of EBITDA; and upper middle market as companies with greater than $100 million in EBITDA. Sponsor-backed core middle market is considered the most competitive area of the market. Upper middle market competes with the BSL market, and, as such, tends to feature weaker terms and less favorable pricing.

The loans will generally be floating rate, based on the secured overnight financing rate (SOFR) plus a credit spread, minimizing interest rate risk, and issued below par to create original issue discount (OID). The loans will be secured by the assets of the company. The fact that the loans are generally secured by all the assets of the company is important as it impacts the recovery value. Historically, first-lien debt has an ultimate recovery value of 70%, while unsecured bonds have a recovery rate of 47%, according to Moody’s.

Senior debt funds may use fund level leverage to increase the capital available for investment in order to increase the returns. Leverage will generally be non-recourse to the LPs and will not be mark to market. The leverage provider could be a bank, another fund, or a structured finance vehicle such as a collateralized loan obligation. The debt used for this purpose will be secured by the loans owned by the portfolio and not by the obligation of the LP to fund a capital call. This is different from a subscription line, which is secured by the fund’s right to call capital from the LPs. Subscription lines do not increase the amount of capital available to invest but instead change the timing of the cash flows, which could increase the internal rate of return. Generally, private credit funds use subscription lines only to facilitate capital calls and will pay the lines down to zero periodically.

Subordinated Capital

Subordinated debt is a loan or security that ranks lower than other loans with regard to claims on assets or earnings. Subordinated debt is a riskier form of debt as it is not repaid until after unsubordinated (senior) debt holders have been repaid in full. Often called mezzanine debt because it ranks between the senior debt and the equity of a company, the debt will frequently include some form of equity, either a co-investment in the common equity alongside the private equity owner or warrants.

The subordinated capital category also includes capital appreciation strategies. These funds will invest, typically in performing companies, anywhere in the capital structure from senior debt to preferred equity. The debt investment will often include some form of equity upside, such as warrants, preferred securities, or in the common equity. As the demand for mezzanine debt has waned in recent years, many mezzanine debt managers have migrated to this strategy. In both traditional mezzanine and capital appreciation strategies, the returns are driven by both the debt security and the equity ownership. Typically, a subordinated capital fund will include between 10% to 20% equity exposure.

Credit Opportunities and Distressed

Credit opportunities refers to a broad range of strategies that are typically opportunistic in nature, meaning they are either investing in companies in stressed or distressed situations, or addressing an unmet capital need in a creative way. Credit opportunities funds may have a broad spectrum of credit and debt-related investments across geographies. Investments can be made in performing, stressed, or distressed companies, and can be directly originated and structured in the primary market or reflect purchases of securities in the secondary market. While the return of a credit opportunities fund will be focused on income, there will often be an element of equity return or capital gain, particularly in more distressed situations.

Credit opportunities managers may pivot to a greater focus on distressed when market default rates rise to elevated levels. Some managers are exclusively focused on distressed situations. Distressed investors target companies or assets where the company is at a high risk of entering bankruptcy or restructuring. While it is not the intent of the fund to own the company, the manager is prepared to take equity through a restructuring and own that equity for a period of time. This strategy differs from distressed for control strategies, where the explicit purpose of purchasing the debt security is to take ownership of the company through a restructuring of the debt. We view distressed for control as more of a private equity–type strategy, as the manager seeks to own and manage companies as its primary activity.

Specialty Finance

Specialty finance managers pursue a very broad array of niche strategies, requiring highly specialized expertise. A key feature of specialty finance strategies is that they provide diversification away from single name corporate risk—either by lending or investing in pools of assets—or investing in assets that are not correlated to equity markets. A common strategy is to lend against a pool of financial assets, such as consumer or small business loans. The fund is essentially funding the non-bank originator of the loans who may remain as the servicer of the loans. The loans are placed into a special purpose vehicle, which insulates the investment from distress at the originator as the loans can be moved to another servicer. The loan will be structured by looking at historical default and loss rates and requiring the originator to retain the first loss piece, or cushion, to the pool. This is similar to the process used to create asset-backed securities. Another common strategy is for the fund to own a portfolio of equipment, such as rail cars or aircraft, and lease the equipment to create a cash flow stream.

Other strategies include investing in royalties. In life sciences, managers may invest directly in the royalty, helping the company or other entity that owns the royalty to monetize its asset by allowing the fund to collect the royalty payment for a period of time. Similarly, in music royalties, the artist can monetize its catalogue by selling the royalty payments. Increasingly, life sciences managers have moved to a lending strategy where the patent is taken as collateral. This will shorten the duration of the investment. Additional strategies include life settlements, insurance, trade finance, litigation finance, and non-performing loans.

Specialty finance can have a wide range of return targets and duration depending on the strategy. Consumer lending tends to be very short, while royalties—particularly music royalties—can be very long dated. Returns can range from the high single digits to the high teens.

Implementation

With the variety of private credit strategies available, we believe it is possible to create a well-diversified portfolio that can generate income and provide some upside. We like to construct portfolios with a mix of senior debt, credit opportunities, and specialty finance strategies (Figure 4). Senior debt strategies generate cash flow and provide a ballast to the portfolio, offering downside protection and income. A credit opportunities strategy should generate returns higher than direct lending during benign markets, and, importantly, will benefit from market stress and dislocations. The funds can offset any stress that may be seen in the senior debt strategies during periods of elevated defaults. An allocation to specialty finance will provide diversification away from single name corporate risk.

When constructing a portfolio, an investor’s primary objective will influence allocation to the different sub-strategies. For example, an income-oriented investor may focus on direct lending strategies, picking a diversified group of managers to gain exposure to sponsor and non-sponsor and across the borrower size categories. This portfolio may also consider an allocation to income focused specialty finance strategies to provide some diversification. The portfolio should provide a stable income stream, 100 bps to 200 bps higher than the public leveraged finance markets, with lower volatility and risk profile.

Investors more focused on returns will gravitate to higher returning strategies in credit opportunities and distressed. Strategies may focus across different asset classes, such as corporate, real estate, and structured products. A portfolio constructed this way could be attractive to a tax-paying investor, as it can focus on strategies that offer a greater degree of capital gain relative to income.

Investors seeking a diversified allocation to private credit may invest across the different sub-asset classes, such as senior debt, credit opportunities, and specialty finance. We believe that a portfolio constructed this way can deliver an attractive income stream, coupled with some higher returning credit opportunities strategies that can also benefit from a dislocation. The addition of specialty finance will serve to diversify away from corporate risk. Investors can weight the components depending on their preference for income relative to higher returning strategies.

Investors allocate to private credit from various parts of their portfolios. Some investors will have a specific allocation to private credit as part of their total portfolio. Investors that allocate from their illiquid buckets will often focus on higher returning strategies as they are comparing the funds to their private equity and venture allocations. In a zero-rate environment, many investors looked to direct lending to improve returns in their fixed income allocations. Finally, many investors have looked to their diversifiers bucket to carve out a piece to allocate to private credit, recognizing that the lock-up nature of the funds is illiquid relative to the rest of that allocation, but that the private credit portfolio can generate some income and an attractive return.

Conclusion

The private credit market has developed and evolved significantly since the GFC. The asset class includes a broad array of strategies to satisfy investors’ return objectives. Strategies can be cash flow generating and offer shorter duration than other private investment strategies. Downside protection creates an attractive risk mitigant relative to private equity and venture strategies. Investors can construct portfolios to provide income, benefit from market dislocations, and provide some diversification away from single name corporate risk.

Frank Fama, Co-Head of Global Credit Investment Group

Walker Haymond, Brittney McManus, and Ilona Vdovina also contributed to this publication.

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

Bloomberg US Corporate High Yield Index
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on the indexes’ EM country definition, are excluded. The US Corporate High Yield Index is a component of the US Universal and Global High Yield Indexes. The index was created in 1998, with history backfilled to July 1, 1983.

Bloomberg US Treasury Index
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting. The US Treasury Index is a component of the US Aggregate, US Universal, Global Aggregate, and Global Treasury Indexes. The index includes securities with remaining maturity of at least one year. The US Treasury Index was created in March 1994, and has history back to January 1, 1973.

Morningstar LSTA US Leveraged Loan 100 Index
The Morningstar LSTA US Leveraged Loan 100 Index is designed to measure the performance of the 100 largest facilities in the US leveraged loan market. Index constituents are market-value weighted, subject to a single loan facility weight cap of 2%.

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.
2. The pending US BIOSECURE Act identifies five Chinese biotech companies that would be prohibited from obtaining US government contracts or deriving revenue from US companies and agencies that receive US government funding. The proposed guidelines do not impose restrictions on US PE/VC investments into Chinese biotech.
3. A J-curve is an early period characterized by negative returns and cash flows, as investments are initially made and develop over time before they are in a position to be sold.
4. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.

The post Private Credit Strategies: An Introduction appeared first on Cambridge Associates.

When we wrote last summer about fertile conditions for credit opportunities funds, we didn’t anticipate how fast risk appetite would rebound as inflation receded. This has allowed borrowers to refinance maturing debt and some to obtain lower spreads on new loans or bonds, but signs of stress still exist. Fundamentals for highly leveraged credits have weakened and credit downgrades continue apace. Whichever way the economy turns during the remainder of 2024, investors in private credit have a growing opportunity set as tailwinds for many strategies remain and, in some cases, are strengthening. Competition from banks and other markets is declining, regulators are blessing new deal structures, and strong historical returns are attracting more capital.

This paper provides an update on recent developments in private credit and highlights several opportunities that investors should explore for the remainder of 2024. We continue to favor direct lending and credit opportunities funds. For investors willing to take more focused bets, we highlight additional strategies that benefit from the ongoing bank disintermediation, such as fund financing—also known as net asset value (NAV) lending—as well as credit risk transfer and real estate loans.

Growth of Private Credit Markets

Private credit markets continue to increase in size and importance. PitchBook estimates they currently stand at around $1.6 trillion (including around $500 billion of dry powder). The US market accounts for the lion’s share (around $1.1 trillion), with Europe accounting for most of the remainder (Figure 1). Just more than half of this sum is invested in direct lending, with distressed and credit opportunities each accounting for around 20%. While fundraising slowed in 2023, this cooling off was welcome as general partners (GPs) and limited partners (LPs) digested record commitments from earlier vintages.

Despite 2023’s slower fundraising pace, transaction levels in some categories held up reasonably well. Direct lending volumes held steady at around $150 billion in 2023, ⁵ with refinancing activity accounting for about half of this volume, given diminished buyout activity reduced demand for new loans. This tended to favor incumbent lenders to companies instead of new entrants, while the average transaction size grew as choppy syndicated loan market conditions created an opportunity for funds to write larger checks (Figure 2). ⁶

Private Credit Returns

Recent and longer-term private credit returns have been healthy despite the headwind from near-zero interest rates that existed until central banks started hiking rates in early 2022. Through September 30, 2023, US direct lending funds returned more than 11% over the preceding 12 months, while mezzanine debt funds posted even higher returns (Figure 3). Looking back further, over the past decade senior lending has returned nearly 9% on an annualized basis, roughly twice the return on public loans, and has outperformed global equities. ⁷ Looking forward, the tailwind from higher base rates and reduced competition from banks should mean recent vintages generate even higher returns, though manager selection will become increasingly important if the economic backdrop deteriorates.

Using public indexes as proxies for other categories suggests some trading-oriented distressed investors have also enjoyed healthy returns. CCC-rated US high-yield bonds returned nearly 20% in fiscal year 2023, nearly 700 basis points (bps) more than the broad high-yield index. The flipside is that, currently, markets offer slimmer pickings, with just 5.9% of high-yield bonds traded at distressed spreads (>1,000 bps), well below historical average (Figure 4). Outside the United States, the distressed debt opportunity based on prices is much larger, but investing in assets like loans from distressed Chinese property developers requires specialized skills and is not a beta play.

Opportunities for Investors

Higher capital requirements, asset quality concerns, and competition for deposits are significantly impacting bank business models and reducing their ability to conduct certain types of business. Some of these forces have been in place for a decade or more and stem from increased regulatory scrutiny following the Global Financial Crisis. Other factors, such as concern around US commercial real estate loans and funding pressures following the March 2023 US banking crisis, are more recent. The upshot for private credit funds is that many banks are looking to reduce risk exposures, which lowers competition in areas like corporate and real estate lending and also creates new opportunities such as risk transfer deals.

Direct Lending

The direct lending opportunity has steadily grown over the past decade as large banks reined in their lending to riskier companies. The market is evolving, with more entrants, growing fund sizes, and larger check sizes as firms marshal resources from a variety of sources—separately managed accounts (SMAs), commingled funds, business development companies (BDCs). Despite the market dynamics mentioned above—specifically stagnant direct lending volumes in 2023—and rising competition, pricing has held fairly steady. Figure 5 illustrates the premium earned by lenders compared to broadly syndicated loans. This premium has persisted even though private loans have experienced lower default rates, ⁸ in part due to better lender protections (covenants), but also because equity sponsors have been willing to step in and support struggling companies.

Not all parts of the market are equally attractive. While larger funds (and related pools) mean private credit firms can write larger checks, they also mean that protections are being diluted as the top end of the market (larger loans) becomes more covenant light and resembles the broadly syndicated equivalent. This may serve to put a ceiling on spreads for these larger loans, as companies can shop debt needs in both public and private markets—though this is less true for loans to small- and medium-sized companies. Still, according to PitchBook, the average direct lending deal size in 2023 was around $170 million, ⁹ well below the traditional $500 million minimum thought required for the broadly syndicated loans market.

Business Development Companies

BDCs are legal vehicles created under the Small Business Investment Incentive Act of 1980 in an effort to stimulate lending to small companies. The remit of BDCs is like that of banks and direct lending funds, and most large BDC managers also offer direct lending vehicles. BDCs can be either public or private, with liquidity for perpetual versions of the latter typically available at set intervals and subject to certain limits. These vehicles are both an additional tool for credit firms to help finance large transactions, as well as a stable and lucrative source of fees (especially given their ability to use leverage up to 2x NAV).

While overlapping with direct lending funds in terms of remit, ¹⁰ public BDCs typically charge higher fees and their prices can materially diverge from the underlying NAV, making them less attractive to many LPs. Private BDCs, in contrast, typically offer periodic liquidity (typically via tender) and are more targeted at institutions and high-net-worth channels. For tactically minded investors, the propensity of some public BDCs to trade below NAV can offer an opportunity to generate above-coupon returns if and when discounts close. This was the case in 2023, with the S&P BDC Index returning 28%, bringing its five-year annualized return to more than 13%. Fees on private BDCs can make them less compelling than direct lending. That said, institutional investors may at times be offered attractive terms (i.e., lower fees, management fee sharing) to help launch new vehicles, with liquidity typically coming in the form of an eventual initial public offering (IPO).

Credit Opportunity Funds

While distressed ratios remain subdued and economic growth has exceeded expectations, some companies have not been able to grow revenues as fast as costs. Part of this dynamic is the delayed impact of higher interest rates, which continues to boost interest expenses and weaken metrics like interest coverage ratios. As shown below, the median CCC-rated issuer doesn’t have enough cash flow to cover its interest expense, and B-rated issuers, which account for a record high percentage of the high-yield and loan markets, are also operating on shakier ground (Figure 6).

These dynamics create a fertile environment for credit opportunity funds, as some borrowers need immediate help finding more sustainable capital structures. Two potential solutions are adding subordinated debt, which includes a payment in kind (PIK) feature, or replacing existing debt with lower coupon substitutes, which offer the lender equity upside through features like warrants. Generally speaking, the investor base for lower-rated credits is smaller (as many funds don’t want to own potential distress candidates and collateralized loan obligations (CLOs) are discouraged from owning CCC loans) and spreads can gap higher as issuers are downgraded. The key for investors contemplating these funds is to consider the strength and resources of the overall platform, because to the extent that these companies need to be restructured, specialized legal and accounting expertise will be required to supplement the ability to buy and sell CUSIPs.

Fund Finance

Relative to direct lending, the business of lending to investment managers and fund investors is a more recent opportunity for private credit funds. Historically, private equity funds typically met liquidity needs via so-called subscription lines, which were backed by committed yet uncalled capital from LPs. These lines were offered by banks and often provided for relatively low costs, given the hope of providing more lucrative services to the funds. Banks have pulled back from this market due to rising capital requirements and the fact that the failure of Silicon Valley Bank removed one of the largest providers. Meanwhile, demand for funding and liquidity is growing. Many private equity firms are looking for capital as they seek to finance GP commitments to new strategies and ever larger fund sizes. At the same time, quiet mergers & acquisitions markets and reduced IPO issuance are increasing hold times and slowing the ability to return or recycle capital. LPs are suffering from similar dynamics, as a slower pace of distributions can impede the ability to make new investments or meet spending needs.

Private credit firms, both on a dedicated basis and as a sub-strategy in multi-strategy funds, have stepped in to fill this gap. These loans can have various terms and security packages and be made to both GPs and LPs. Variables include the type of collateral (typically they are against the NAV of the underlying investments in the fund), the types of funds (buyout, venture), and whether they are also backed by other fee income. Generally speaking, loans against fund NAV tend to have low loan-to-values (LTVs) and seniority in terms of other distributions to both LPs and the GP. This market, which is currently estimated to be around $100 billion in value, is expected to grow rapidly, given the overall size of the private equity market. LPs can potentially earn attractive returns in this space, but should work closely with a skilled manager, given potential fluctuations in collateral value (and thus security for lender), as well as possible mismatches between the term of the loan and when the underlying collateral can be sold.

Real Estate Lending

Outstanding US commercial real estate loans total almost $5 trillion, and banks have provided around 40% of this total (Figure 7). Around 40% of these loans will mature over the next three years and some will face refinancing risk, given asset values have declined and higher interest rates weaken debt coverage ratios. Meanwhile, at least some banks are looking to reduce exposure to these markets, given higher capital requirements and/or investor pressures. Funding from other sources such as CMBS, CRE CLOs, and mortgage REITs also has become constricted. These vehicles are experiencing higher-than-expected losses, and some have seen payment streams from lower-rated tranches imperiled, raising questions about future investor demand.

The vacuum that is being created generates sizable opportunities for private credit funds willing to make new loans, as does the dislocation in the meantime as falling asset values and deteriorating fundamentals force some holders to sell existing loans or securities. A variety of private debt funds already play in these markets, while the pipeline of fund launches is building. Approaches can vary, with some funds targeting new loans to specific property types (e.g., hotel or apartment specialists), while others are taking a blended approach by combining new loans with purchases of existing loans and structured finance instruments (CLO and CMBS). Return potential varies in line with risk; for example, funds looking to provide loans to stabilized assets at low LTVs are seeking mid/high single-digit unlevered returns, while others willing to provide mezzanine or preferred equity may be aiming for low double-digit returns. Given declining property valuations and the prospects that some assets will need to be recapitalized with equity, real estate equity funds should also find ample opportunities, though the cash flow profiles of these funds for investors will be quite different from those of the debt funds described above.

Significant Risk Transfer

Significant risk transfer (SRT), also known as credit risk transfer (CRT) transactions, involve banks buying protection (thus transferring default risk) on a pool of loans from a counterparty in exchange for periodic payments. Structures can vary, though credit-linked notes (which reference the pool) either issued directly from a bank’s balance sheet or from a separate special purpose vehicle (SPV) are commonly used. Banks engage in these deals to reduce required capital amounts, while at the same time keeping loans and thus maintaining relationships with underlying borrowers (reference risk can be large corporates, small- and medium-sized enterprises, CRE, etc.). Outstanding volumes grew around $25 billion in 2023 to $200 billion globally and are expected to continue growing briskly. ¹¹ Banks face capital shortages or are not inclined to issue more capital at dilutive levels, while at the same time changing capital requirement regimes (e.g., Basel 4 or Basel 3 Endgame) are increasing in many instances the amount of capital they need to hold against assets.

Figure 8 illustrates some simple math on a deal, with the bank in this example transferring risk (buying protection) on a $100 million pool to a SPV. The SPV in turn purchases protection (issues a credit-linked note) from a credit fund on the first potential 12.5% of losses in the pool. The bank (purchaser of protection) pays an annual premium to the SPV, which in turn pays a coupon on the note. The capital required to be held by the bank falls as its risk-weighted assets shrink under two dynamics. The notional amount of assets falls by 12.5% to $87.5 million. But more importantly, the “risk weight” that drives how much capital the bank must hold against these assets also falls given the lower risk profile. In this example, the bank’s risk-weighted assets fall from $100 million (100% risk weight * $100 million) to $17.5 million (20% * $87.5 million), reducing the amount of capital the bank needs to hold by 82%.

CRT transactions are not new. European banks have been significant issuers for years and issuance from countries like Canada has recently ticked up. Long anticipated clarification from the Federal Reserve last September on the risk transfer process for US banks sparked a wave of deals in fourth quarter 2023, led by J.P. Morgan. This is expected to continue into 2024 and beyond. Given that the technology used to structure these deals is not new and some loan pools are somewhat commoditized, returns from certain transactions may be lower than others. However, as issuance rises and skilled credit firms can exercise their advantage sourcing and underwriting more complex pools, credit funds and their LPs will have an opportunity to potentially earn healthy returns.

Conclusion

Many tailwinds for private credit remain in place and in some cases are even getting stronger; banks continue to step back from markets like corporate and real estate lending, and private funds are able to execute ever larger and more complex solutions. The flipside is that headwinds are also growing, be they diminished lender protections for upper-middle-market direct lending or rising stress in some parts of the market. We continue to think that opportunities abound for private credit investors and a variety of markets offer compelling risk/reward. This said, choosing the right partner is essential, and whether a “rifle shot” allocation to a given strategy is appropriate depends greatly on the quality of the GP, as well as the illiquidity and risk tolerance of the LP.

Wade O’Brien, Managing Director, Capital Markets Research
Guillermo Garcia Montenegro and Ilona Vdovina also contributed to this publication.

Footnotes

1. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.
2. The pending US BIOSECURE Act identifies five Chinese biotech companies that would be prohibited from obtaining US government contracts or deriving revenue from US companies and agencies that receive US government funding. The proposed guidelines do not impose restrictions on US PE/VC investments into Chinese biotech.
3. A J-curve is an early period characterized by negative returns and cash flows, as investments are initially made and develop over time before they are in a position to be sold.
4. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.
5. See Hugo Pereira, “2023 Direct Lending Review,” Loan Syndications and Trading Association (LSTA), January 31, 2024.
6. See Fang Cai and Sharjil Haque, “Private Credit: Characteristics and Risks,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, February 23, 2024.
7. The ten-year AACR for MSCI All Country World Index ($ gross) was 8.1% as of September 30, 2023.
8. See Lisa Lee, “Private Credit’s Default Recovery Rates Are Worse Than Its Biggest Rival,” Bloomberg L.P., March 21, 2024.
9. See Joyce Jiang, Vishwas Patkar, and Vishwanath Tirupattur, “Deciphering the Credit in Private Credit,” Morgan Stanley, February 9, 2024.
10. BDCs are technically allowed to own up to 30% non-qualifying assets, such as equity, but typically own well below this limit.
11. See Esteban Duarte and Cecile Gutscher, “BlackRock Manager Predicts 40% Jump in Bank Risk Transfer Deals,” Bloomberg L.P., March 6, 2024.

The post Private Credit Markets Are Growing in Size and Opportunity appeared first on Cambridge Associates.