Published on January 12, 2024
How Private Credit Can Work in a Modern Portfolio
Fixed Income: Navigating One of the Worst Treasury Bear Markets of All Time
The traditional 60/40 portfolio has stood the test of time for most risk-averse investors. As its name states, this portfolio typically comprises a 60% allocation to equities for capital appreciation and a 40% allocation to fixed income for income and risk management. As we have seen in recent years, in a rising interest rate environment this model struggles to meet the needs of its investor base, calling into question the “40%” allocation to fixed income. To understand the basics of fixed-income investing, it is crucial to know the dynamics that impact the price movement of fixed-income assets. The primary factors influencing pricing are yield and credit quality, often represented by the credit spread, which is the disparity between the yield on a risk-free asset and the asset’s yield. It is important to note that bond prices have an inverse relationship with their yields. Given the current macroeconomic environment of high inflation and interest rates, traditional fixed-income assets have not experienced favorable price action, and have thus negatively impacted a significant portion of an investor’s 60/40 portfolio. Bank of America’s Michael Hartnett noted Treasury debt losses over the past three years have amounted to the most severe bear market in US history.
Rebuilding the “40%” Portfolio Allocation in a High-Interest Rate Environment
For those looking to expand their fixed-income portfolios beyond traditional lending products, Private Credit may be your solution. With the failure of Silicon Valley Bank and a few other regional banks this past spring, many banks have become more selective about loans to higher risk companies in an effort to de-risk. Private Credit managers have stepped in to fill the void while setting more lender-friendly terms. In this arrangement, lenders interact directly with borrowers to negotiate and initiate privately held loans that are not publicly traded. By bypassing public markets, private credit provides a flexible and tailored solution for borrowers seeking unique funding opportunities.
Spectrum of Public and Private Credit
Private Credit refers to a lending practice that operates outside of the conventional banking system. Private debt loans are typically issued on a floating-rate basis, linked to benchmarks like Three-month LIBOR or SOFR, with a fixed spread. This structure adjusts the cash flows based on interest rate changes, providing cushioning against rate changes. During periods of increasing interest rates or high inflation, floating-rate bond structures have demonstrated their ability to mitigate the impact on a bond's price. Additionally, in a risk-averse market environment where credit spreads are widening, diversification plays a crucial role in minimizing the risk of any individual asset's credit quality deteriorating.
Private Credit Funds as a Fixed Income Replacement
Private Credit funds offer significant advantages, making them a compelling option for investors. These funds are typically invested in a diverse pool of hundreds, and sometimes thousands, of private loans and debt securities. This diversification spans various factors such as industry, duration, location, and debt structure, which results in a well-balanced portfolio. Despite being categorized as an illiquid asset class, Private Credit has shown its ability to deliver superior returns with lower default and loss rates relative to high yield and leverage loan indices. Another interesting perk for investors during high periods of market volatility is that these credit funds price positions and distribute cash on a quarterly basis, avoiding daily fluctuations experienced in publicly traded bonds.
Enterprise Software, a Natural Fit for Private Credit
As we look at the underlying assets held by Private Credit funds, Enterprise Software is one key sector that has remained resilient in this turbulent market. Enterprise Software impacts various end markets and is often dubbed a “mission-critical expense.” It has become increasingly popular in the investment community due to its visible and recurring revenue streams, strong free cash flow, high profitability, and attractive loan-to-value ratio.
To truly grasp the appeal of Enterprise Software, it is crucial to understand its customer base is made up of businesses and not individual consumers. Consumer spending trends tend to fluctuate with the economy. On the other hand, corporate spending on enterprise software tends to be much more stable and less susceptible to potential budget cuts.
Private capital, including both Private Equity and Private Credit, has recognized the benefits of lending to software companies, with enterprise software spending being more predictable and durable than it was in previous economic cycles. As business models have evolved to SaaS and subscription models, which require much smaller variable expenses, the result has been more predictable revenue streams with a product that is easier to adopt. As forecasted by Gartner, Enterprise Software spending is set to top $923 billion, growing almost 14% since 2022.
Worldwide IT Spending Forecast (Millions of U.S. Dollars)
|Data Center Systems
Investment Risks of Private Credit
Investing in Private Credit funds carries certain risks that should be considered. Illiquidity is a significant concern for many investors, as Private Credit investments typically have lock-up periods, which limit quick access to the invested principal. While publicly traded bonds can be liquidated relatively quickly, Private Credit, like Private Equity, requires patience and a longer time horizon. Additionally, it's important to understand the underlying companies to which these loans are being issued. In some instances, loans in this sector are extended to stressed and/or distressed companies. While diversification helps mitigate risk, the refinancing of underlying obligors' debt may prove more challenging compared to traditional capital market borrowers. Despite these considerations, investing in Private Credit can lead to attractive yields, although investors should carefully evaluate their risk tolerance and overall investment strategy.
Private Credit assets have experienced significant growth in recent years. However, it is crucial to recognize that not all Private Credit offerings are equal in terms of quality. Building upon the concept of resilience, we firmly believe that manager selection is a critical component. When evaluating the Private Credit landscape, it becomes paramount to distinguish between managers who have successfully navigated various market cycles and emerged stronger, and those who are nascent. Managers who lack exposure to multiple industry cycles might not be as resilient as more experienced managers.