In the continuing low-interest-rate environment, the pursuit of yield remains the dominant theme for both institutional and private investors, writes LGB Investments’ Managing Director Simone Westerhuis.
Faced with volatility and uncertainty in public markets, investors have increasingly turned to alternative asset classes for uncorrelated returns and, particularly, income. There is growing appetite for private credit among high net worth individuals (HNWIs) and family offices (FOs), with some investors now committing some 11% of their investable funds to this asset class. With interest rates remaining at an unprecedented low and equity markets continuing to fluctuate, we anticipate that this trend is set to remain.
The growing popularity of private credit via a range of funding instruments including specialist investment trusts, funds, Peer2Peer platforms (P2P) and secured loan notes, lies primarily in the strength of the risk-adjusted return. As an alternative asset class not only does it offer diversification and steady cash flows, it is also uncorrelated to the stock markets whilst generating a significantly higher yield than the traditional fixed-income markets. Whereas annual yields on publicly traded corporate bonds currently generate yields of two to five percent, typical interest rates for private credit transactions can easily double this.
The higher-than-average annual yield that can be generated by private credit investments compared to corporate bonds can be explained by two main factors. The first is the impact of quantitative easing programmes by the central banks, which have pushed up the market price of publicly traded bonds, forcing down the yields. The second is the growing strangle-hold of regulation around the major banks’ ability to lend – particularly to growth businesses – which has made them inflexible, time-consuming lending counterparties. Borrowers are often prepared to pay a premium in a private credit transaction to avoid dealing with banks, in return for increased flexibility and speed of execution.
HNWI and FO investors are particularly well positioned to benefit from the growing appetite from businesses for non-bank funding. Compared to conventional fund managers, whose investment activities are more strictly regulated and who need to mark-to-market their investments, secondary market liquidity is less important to private investors. Additionally, in recent years the high fees and poor performance of hedge funds has led HNWIs and FOs to reduce their allocations to this asset class. As well as private equity and real estate, some of those funds have been reinvested in the private credit markets.
However, wealthy lenders should be cautious about the quality of companies to which they lend and the intermediaries or platforms that manage the loans. While P2P platforms have simplified the value chain, P2P can represent significantly greater credit risk than other forms of lending, with defaults effectively equalling losses. Even though some platforms may have put safeguards in place to offer a degree of protection, investors tend to have little or no direct insight into the borrowers, which traditional financial intermediaries may have rejected due to a high likelihood of defaults. As the market grows and matures, transaction volumes on the main platforms are beginning to plateau, with the danger of P2P lenders tempted to finance riskier investments to maintain growth and market share.
Another popular way for HNW investors to take advantage of the return potential of private credit is via investment trusts and funds, which offer access to diversified lending portfolios and provide a level of protection against defaults via established debt recovery procedures. Risks may vary greatly between such funds if the investment manager chooses to add leverage in the fund to boost returns. The key to success will often depend not only on the manager’s ability to analyse risk, but also on its access to deal flow and ability to fix problems when they occur.
Secured loan note programmes, which provide secured private debt transactions for SMEs, have common loan documentation relating to the security and inter-creditor arrangements, with a security trustee appointed as a single counterparty to engage with the borrower on behalf of all the lenders. The advantage for investors is that borrowers offer frequent investment opportunities and can often accommodate reverse inquiries.
As such, investors can become familiar with the borrower’s business in order to take an informed investment decision, in the knowledge that robust arrangements are in place to look after their interests should anything happen to the borrower during the life of the loan.
A significant attraction of the notes is their fixed interest rate, typically between six and ten percent per annum, and the relative short maturities ranging from six months to five years. Interest rates will reflect the credit standing of the issuer, but may vary with investor demand. As borrowers establish a strong track record with investors, they may be able to lower the rate they pay to their investors.
The key for investors is to have a portfolio approach to their private debt allocation, ensuring sufficient diversification to smooth investment returns and reinvest capital generated via interest and redemptions efficiently. For investors who do not have sufficient resources to analyse investment opportunities and manage their own portfolios, we offer a discretionary management service which is tailored to their objectives and risk profile.
As macro trends continue to make private credit and SME lending attractive to private investors, the return differential relative to cash deposits or traditional fixed income allocations does imply credit risk. However, when allocated as part of a balanced investment portfolio, secured loan note programmes can offer HNWIs and family offices attractive risk adjusted fixed income returns with steady cash flows.
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This article was originally published in WhatInvestment, which you can read here.
