CONTRIBUTORS
Tony Davidow, CIMA®
Senior Alternatives Investment Strategist
Franklin Templeton Institute
Priya Thakur, CFA, CAIA
Analyst
Franklin Templeton Institute
Key points
- Private credit has historically delivered an “illiquidity premium” relative to public-- market equivalents
- Private credit can serve as an alternative source of income
- Private credit has historically delivered attractive risk-adjusted results relative to traditional fixed income
- Private credit can provide diversification benefits relative to traditional fixed income
We see parallels to the post-global financial crisis (GFC) market environment, where private credit managers stepped in to fill the void that traditional banks had left. In a post-SVB market environment, private credit managers will have the upper hand in negotiating favorable pricing, terms, and covenants.”
Advisors and investors have been questioning the merits of the “60/40” portfolio in today’s market environment. Specifically, they have been seeking alternative sources of return and income, broader diversification, downside protection and inflation hedging. Not surprisingly, private credit investments have been garnering a lot of attention from advisors and high-net-worth (HNW) investors due to their unique characteristics.
Private credit represents a diverse set of strategies, from direct lending to mezzanine and distressed debt. Private credit strategies invest in instruments that are mostly privately negotiated and not publicly traded; and private-credit instruments are originated by non-bank lenders.
The types of investments private-credit funds make can vary significantly, from a newly originated loan in a fast-growing company, to a distressed investment in a company running out of cash. The various types of private credit can be divided into discrete strategies.
Direct lending includes senior secured—first lien and unitranche—loans to middle-market companies. Mezzanine lending is the origination of unsecured, subordinated debt, often in conjunction with a private equity buyout transaction. Distressed credit includes investments in the debt of financially troubled companies facing liquidity issues. Specialty finance, such as aircraft finance, royalties and life settlements represent a growing segment of private credit.
Each of these types of private credit introduce their own unique risk-return and income characteristics. These investments can be used to provide diverse portfolio outcomes, such as increasing returns, alternative sources of income, diversification relative to traditional fixed income, and hedging inflation.
In this paper, we explore:
- The growth of private credit
- The types of private credit
- The role of private credit
- Public versus private credit
- Accessing private credit
Advisors and investors have been questioning the merits of the “60/40” portfolio in today’s market environment. Specifically, they have been seeking alternative sources of return and income, broader diversification, downside protection and inflation hedging. Not surprisingly, private credit investments have been garnering a lot of attention from advisors and high-net-worth (HNW) investors due to their unique characteristics.
Private credit represents a diverse set of strategies, from direct lending to mezzanine and distressed debt. Private credit strategies invest in instruments that are mostly privately negotiated and not publicly traded; and private-credit instruments are originated by non-bank lenders.
The types of investments private-credit funds make can vary significantly, from a newly originated loan in a fast-growing company, to a distressed investment in a company running out of cash. The various types of private credit can be divided into discrete strategies.
Direct lending includes senior secured—first lien and unitranche—loans to middle-market companies. Mezzanine lending is the origination of unsecured, subordinated debt, often in conjunction with a private equity buyout transaction. Distressed credit includes investments in the debt of financially troubled companies facing liquidity issues. Specialty finance, such as aircraft finance, royalties and life settlements represent a growing segment of private credit.
Each of these types of private credit introduce their own unique risk-return and income characteristics. These investments can be used to provide diverse portfolio outcomes, such as increasing returns, alternative sources of income, diversification relative to traditional fixed income, and hedging inflation.
In this paper, we explore:
- The growth of private credit
- The types of private credit
- The role of private credit
- Public versus private credit
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Investments in many alternative investment strategies are complex and speculative, entail significant risk and should not be considered a complete investment program. Depending on the product invested in, an investment in alternative strategies may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. An investment strategy focused primarily on privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity. Diversification does not guarantee a profit or protect against a loss.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price. Past performance does not guarantee future results.