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

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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. ¹

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 ² 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. 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.
2. 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.

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Footnotes

1. 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.
2. 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 APAC LPs Keen on Private Credit 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 and venture capital.

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. 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.
2. 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, ³ 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). ⁴

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. ⁵ 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, ⁶ 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, ⁷ 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, ⁸ 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. ⁹ 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. 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.
2. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.
3. See Hugo Pereira, “2023 Direct Lending Review,” Loan Syndications and Trading Association (LSTA), January 31, 2024.
4. 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.
5. The ten-year AACR for MSCI All Country World Index ($ gross) was 8.1% as of September 30, 2023.
6. See Lisa Lee, “Private Credit’s Default Recovery Rates Are Worse Than Its Biggest Rival,” Bloomberg L.P., March 21, 2024.
7. See Joyce Jiang, Vishwas Patkar, and Vishwanath Tirupattur, “Deciphering the Credit in Private Credit,” Morgan Stanley, February 9, 2024.
8. BDCs are technically allowed to own up to 30% non-qualifying assets, such as equity, but typically own well below this limit.
9. 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.

The conversation explores private equity’s low 2023 transaction volume and why distribution rates back to LPs are at their lowest point in nearly 25 years. Andrea explains that while we’ve “gone from fourth to first gear in the private equity markets because of interest rates, it’s created a moment for private credit to shine.”

Listen to the full episode.

Footnotes

1. 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.
2. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.
3. See Hugo Pereira, “2023 Direct Lending Review,” Loan Syndications and Trading Association (LSTA), January 31, 2024.
4. 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.
5. The ten-year AACR for MSCI All Country World Index ($ gross) was 8.1% as of September 30, 2023.
6. See Lisa Lee, “Private Credit’s Default Recovery Rates Are Worse Than Its Biggest Rival,” Bloomberg L.P., March 21, 2024.
7. See Joyce Jiang, Vishwas Patkar, and Vishwanath Tirupattur, “Deciphering the Credit in Private Credit,” Morgan Stanley, February 9, 2024.
8. BDCs are technically allowed to own up to 30% non-qualifying assets, such as equity, but typically own well below this limit.
9. See Esteban Duarte and Cecile Gutscher, “BlackRock Manager Predicts 40% Jump in Bank Risk Transfer Deals,” Bloomberg L.P., March 6, 2024.

The post Bloomberg Intelligence: State of Private Markets appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ¹⁰ and ARPA ¹¹ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ¹² calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ¹³

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Serge Agres, Managing Director, Pension Practice

Cathy Xu, Investment Director, Pension Practice

Footnotes

1. 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.
2. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.
3. See Hugo Pereira, “2023 Direct Lending Review,” Loan Syndications and Trading Association (LSTA), January 31, 2024.
4. 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.
5. The ten-year AACR for MSCI All Country World Index ($ gross) was 8.1% as of September 30, 2023.
6. See Lisa Lee, “Private Credit’s Default Recovery Rates Are Worse Than Its Biggest Rival,” Bloomberg L.P., March 21, 2024.
7. See Joyce Jiang, Vishwas Patkar, and Vishwanath Tirupattur, “Deciphering the Credit in Private Credit,” Morgan Stanley, February 9, 2024.
8. BDCs are technically allowed to own up to 30% non-qualifying assets, such as equity, but typically own well below this limit.
9. See Esteban Duarte and Cecile Gutscher, “BlackRock Manager Predicts 40% Jump in Bank Risk Transfer Deals,” Bloomberg L.P., March 6, 2024.
10. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
11. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
12. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
13. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post A Changed Investment Landscape Is Providing Greater Opportunity for US Corporate Pensions appeared first on Cambridge Associates.

US High-Yield Bonds Should Outperform Loans in 2024

Wade O’Brien, Managing Director, Capital Markets Research 

Leveraged loans are on track for their third consecutive year of outperformance compared to US high-yield (HY) bonds for the first time in more than 20 years. This is unlikely to continue in 2024 as leveraged loans face greater headwinds from slowing economic growth and rising debt servicing costs.

Rising short-term yields have boosted loan coupons and returns but hurt issuer fundamentals. Loan interest coverage ratios have dropped from 4.4x at the end of 2022 to 3.0x at the end of third quarter 2023 and are even lower once expenses, such as maintenance capex, are considered. Ratios look even shakier for the weakest borrowers that have driven recent performance. B- rated borrowers have a coverage ratio of less than 2x. US loan default rates (3.1% over the past 12 months) already outpace those of bonds and higher rating downgrade ratios suggest this will continue. Further, weak loan documentation and an increasing share of loan-only issuers mean these defaults will continue to prove more painful for investors.

In contrast, HY index coverage ratios have also declined but remain much higher (around 5.0x as of mid-year). Much smaller HY index weights for lower rated (B- and CCC) issuers are one explanation. Looking forward, the gap between HY and loan issuer fundamentals should widen as the impact of higher short-term rates continues to be reflected in loan issuer borrowing costs.

While we think HY bonds will outperform loans in 2024, we remain neutral overall, given current spreads are below their historical average and levels typically seen during recessions. HY defaults are likely to rise, especially if growth disappoints in 2024. Loan defaults also could prove manageable if weak covenants provide companies more cushion and/or private equity owners step in to provide support. Given these dynamics, our preferences in liquid credit remain for securitized assets like investment-grade collateralized loan obligation debt, where yields are in mid-to-high single digits and elevated spreads provide cushion if issuer fundamentals deteriorate in 2024.

Direct Lending Strategies Should Deliver Above-Average Returns in 2024

Frank Fama, Co-Head of Global Credit Investment Group

After a decade-plus era of cheap money, the higher-rate environment will continue to directly benefit the floating-rate direct lending asset class. Direct lending strategies tend to provide steady cash flows, generate consistent returns, and distribute capital at a faster rate than other private investment strategies, particularly in today’s environment. We expect that direct lending strategies will deliver returns above the long-term average of 6% to 7% for unlevered funds and 8% to 10% including fund level leverage, given attractive current yields and solid underwriting standards.

Direct lending funds provide first-lien senior-secured loans to middle-market companies. These loans are typically floating rate and had a yield of around 7% when rates were low. Currently, with three-month secured overnight financing rate roughly 550 bps and credit spreads around 600 bps, investors are enjoying low double-digit asset yields. Direct lending funds will distribute that income quarterly.

Loans structured in the current environment are more favorable to lenders than in the recent past. In a higher-rate environment, debt capacity of borrowers is lower, meaning leverage levels have come down and sponsors are contributing more equity to transactions. Financial covenants are being set tighter, helping to protect downside if the borrower underperforms. Additionally, loan funds will have a shorter duration than other private investment asset classes. Loans will typically have a maturity of five years and an average life of three to four years, so distributions to LPs will begin shortly after the end of the investment period.

Direct lending strategies have grown significantly over the last ten years amid a period of low interest rates and a strong economy, leading to low defaults. This has resulted in a period of little dispersion in returns. While today’s attractive all-in yields are an opportunity for lenders, they also increase borrowers’ interest expenses and potential risk. We expect that managers with experience across credit cycles and the discipline to maintain underwriting standards will differentiate themselves from the pack.

European Opportunistic Private Credit Funds Raised in 2024 Should Deliver Above-Average Returns

Vijay Padmanabhan, Managing Director, Credit Investments

European credit opportunities funds have returned an underwhelming 7.0% since mid-2011 against a targeted return in the mid-teens. A decade of near-zero interest rates gave corporates easy access to low-cost capital and allowed them to build strong balance sheets. Except for short periods of market dislocations or isolated cases of stress, it was mostly a challenging time for funds that specialize in providing highly structured customized solutions to balance sheet problems. But we believe this is set to change in 2024, as we expect corporates to actively look for ways to reduce interest costs and improve liquidity.

With interest costs almost doubling and operating costs remaining high, we have started to see a decline in key coverage ratios. One key metric, EBITDA-to-interest expense ratio for European buyouts, has fallen from 4.3x in 2022 to 2.5x in 2023. This goes to show the declining level of cash generation by corporates due to the rise in costs. We are likely to see more dispersion in credit with companies in certain sectors and geographies facing more pressure than others.

Since 2022, the pace of public market debt issuance has slowed, and European banks have pulled back to focus on their regulatory capital requirements. We have seen the commercial real estate market come under immediate pressure post-COVID. Pockets of distress are emerging in sectors, such as financial services and healthcare, as pandemic- induced financial support has waned. Credit strategies that can provide capital solutions to larger corporates that otherwise would have accessed public market and/or that can pivot into distressed opportunistically will see a robust deployment environment in 2024. While individual manager performance will, of course, vary, we expect next year’s vintage of European opportunistic private credit managers will deliver above-average returns.

Footnotes

1. 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.
2. All financial investments involve risk. Depending on the type of investment, losses can be unlimited. Past performance is not indicative of future returns.
3. See Hugo Pereira, “2023 Direct Lending Review,” Loan Syndications and Trading Association (LSTA), January 31, 2024.
4. 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.
5. The ten-year AACR for MSCI All Country World Index ($ gross) was 8.1% as of September 30, 2023.
6. See Lisa Lee, “Private Credit’s Default Recovery Rates Are Worse Than Its Biggest Rival,” Bloomberg L.P., March 21, 2024.
7. See Joyce Jiang, Vishwas Patkar, and Vishwanath Tirupattur, “Deciphering the Credit in Private Credit,” Morgan Stanley, February 9, 2024.
8. BDCs are technically allowed to own up to 30% non-qualifying assets, such as equity, but typically own well below this limit.
9. See Esteban Duarte and Cecile Gutscher, “BlackRock Manager Predicts 40% Jump in Bank Risk Transfer Deals,” Bloomberg L.P., March 6, 2024.
10. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
11. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
12. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
13. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

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