Private Credit Is Fast Becoming A Permanent Fixture In Portfolio Investing

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The expectation for a lasting near-zero interest rate environment had settled in many investors’ minds as early as six or seven years ago. It was a hangover of sorts from the economic changes brought on in response to the Great Financial Crisis, which suggested a new normal in how the Fed operates.

This undoubtedly encouraged credit investors to look beyond traditional portfolio construction to meet their return expectations, and more so, their income benchmarks. In turn, managers at pension funds, insurance companies, college endowments and foundations began increasing their exposure to alternatives. Although many advisory firms and multi-family offices have well-staffed investment teams (some with a specific focus on alternatives), the moves being made within the institutional investor community tend to be a leading indicator of where the more individualized wealth management industry goes.

According to Pitchbook, nearly $200 billion was raised just last year by private debt managers globally – a 12% year-on-year gain as compared to 2020. It now stands as the third largest alternatives asset class behind private equity and venture capital. Fixed income – traditionally corporate bonds and treasuries – used to be a ballast for investment portfolios, providing the benefits of diversification, capital protection and yield. But it has looked less attractive over the past 10 years. Ultra-low interest rates and a historically accommodative monetary tend to have that effect.

The rapid growth of the private credit markets was in part a response to the unfulfilled promises of traditional fixed income classes of credit. It also was the result of post-Dodd Frank regulation of big banks, which reduced risk taking and generally weighed on lending operations, as well as the unabated growth of private deal making.

So, with pressures ranging from geopolitics to inflation, increasing attention being paid to a diverse set of alternative investment strategies and a growing chorus questioning the wisdom of traditional portfolio design, what exactly is private credit today. And why aren’t more investors, especially family offices, taking advantage?

To put it simply, private credit is a broad collection of investment strategies but can generally be characterized by bespoke deal structures, floating interest rates, bi-party or at least non-syndicated transactions, and increased governance, borrower access and information. These are all quite favorable qualities, and maybe even more so in a market defined by its recent volatilities and inflationary pressures.

And while the family office set is certainly getting more active in private investing – becoming a player in everything from early stage funding to SPACs, there tends not to be much uniformity in how family offices build their portfolios. On balance, they are likely not taking advantage of alternative credit in as many ways as they could and perhaps should. This is at a time when two-thirds of institutional investors plan to increase their allocations to private credit in the coming year. Returns have been strong and according to the Proskauer Private Credit Default Index, the default rate for middle market businesses fell to just 1.04% in Q4 2021.

One could argue that this figure is unnaturally low (and directionally consistent with the default rate of larger corporate borrowers), but it no doubt challenges the fear that transacting in the private market is fundamentally more risky. 

There are a few reasons why private credit has not found a more energetic audience with family offices.  Family offices are built on the successes of their matriarchs and this evidence corroborates the wealth of business acumen, having a nose for profitably pricing risk, and an ability to compound meaningful personal investment that is at their disposal. In other words, these firms are founded by individuals that know how to make money.

Whether real estate or venture capital, private investments tend to be the more active part of their portfolios. It is perhaps no wonder that low multiple, even mid-teens return opportunities don’t command the same attention from this set as venture moonshots. Private credit is also typically very tax punitive. Together with its often-capped returns leave little to the imagination as compared to higher velocity (and to be sure, higher volatility) alternative strategies like private equity or VC.

Lastly, credit tends to be quite arcane for many investors. Its beauty lies in the legal documentation and structuring of an investment – not quite the same as a growth thesis or aggressive acquisition strategy.

In periods of volatility, private credit tends to outperform. It is during these times of uncertainty and market stress that credit proves its worth in investor portfolios. Demand will likely remain strong, particularly as performance remains strong – which there is no reason to believe it wouldn’t. Individual investors with the wherewithal to build a portfolio of alternative strategies and family offices would do well to follow the lead of their largest institutional peers and build a foundational allocation to this attractive collection of investment strategies.