Private Credit Investing: A Deep Dive

As balance sheets tighten and the costs of financing get more complicated while legal and regulatory requirements of the public banking system crack down, corporations are exploring other avenues by which to attain funding. Facing the tightening of credit standards and a rise in interest rates, public banks have also become less willing to be the source of funding for middle-market private companies. Looking at consumer mentality, we see the recent bank failures at Silicon Valley Bank and Credit Suisse provoking wary attitudes towards the stability and security of commercial bank lending.

Supporting this sentiment, the federal reserve reports that since interest rates began to rise last year, more than $1 trillion of household deposits have left the US banking system. This departure adds to the bank retrenchment that had already begun after the global financial crisis. As banks continue to retreat from lending, we expect the private credit sector to continue to provide attractive long-term opportunities for investors.

As alternative investment advisor Cliffwater LLC discussed in their Q3 update, deal flow has faced a bit of a cooling period, despite being higher since the start of 2023. The macroeconomic environment has continued to be a challenge, as this high-rate environment has borrowers looking elsewhere to cool the current lending stress. We have seen encouraging signals in the syndicated loan market, as these large and secure deals have begun to move into the private credit space with more lenders able to effectively deploy capital. High-grade bond sales indicate a big uptick in deal flow, as companies exit their earnings blackout period and begin to clear debt off their books.

The private debt market has seen substantial growth, with a sixfold increase since the economic collapse in 2008, amassing into a $1.2 Trillion market as of 2022^[1]. With the success of large private credit firms, such as Ares and Blackstone, investors and money managers alike have since invested in the space in hopes of achieving the high returns that these funds can produce.

Relative to the traditional fixed income strategies that are trading in the public markets, private credit funds can structure the debt in accordance with the thesis of the fund and without the restrictions present in bank lending. This allows for more leverage and flexibility in terms of lending strategies and repayment structure.

The principal risk involved with these fixed income investments is distress at the underlying loan level. In a high-interest-rate environment, the risk of defaults and delinquencies increases, resulting in potential for repayment failure. This could lead to volatility in the fund, as the underlying loan obligations feel the downward pressure of high interest rates, as well as uncertainty regarding the safety and validity of the issued debt. In the case of defaults, private credit funds will experience volatility and need to be rebalanced, which can lead to sponsors, the private equity firms, writing down the investment.

Funds may also leverage its investments by use of swap agreements, options or other derivative instruments, use of short sales, or the issuance of preferred stock or preferred debt. Should the securities and other assets pledged as collateral decline in value or should brokers increase their maintenance margin requirements, the fund could be subject to a margin call.

The lack of transparency is also a potential risk of this investment vehicle, as the companies participating in this unconventional fundraising platform are often small private corporations with an influx of capital and little exposure to direct funding. Loans that were underwritten in the prior years' low-rate environment are starting to see distress and tightening at the repayment level, causing a higher rate of defaults.

Private credit managers’ response to the inherent risks within direct lending and delinquencies involves rebalancing and re- allocation, which is achievable due to the free flow of capital established in the loan agreements. Fund managers underwrite the downside case, rather than model the upside, which protects the fund from high exposure to delinquencies and gives them the ability to move laterally in the case of defaults. Private debt is commonly comprised of senior loans, which ranks higher than other debt in the capital structure, reducing risk in the case of default.

Funds limit their borrowings in order to reduce the risk of their leverage and/or the instance of a margin call. Variant Alternative Income Fund, for example, limits its borrowings to no more than 50% of its total assets for preferred stock and preferred debt and 33 1/3% of its total assets for debt securities, including amounts borrowed, measured at the time the investment company incurs the indebtedness.

Experience at manager level is ultimately essential in this asset class, as diligence and recognition of defaults allows for quicker reactions and reallocation to decrease the probability of volatile returns and defaults.

Chicago Partners has focused on a handful of funds led by investment teams with decades of experience investing in niche markets, the majority of which are non-diversified closed-end management fund investment companies that operate as interval funds. Part of our interest in these funds is influenced by this interval nature that provides investors with such features as daily pricing, 1099 tax reporting, and quarterly liquidity.

Our performance analysis on private credit relies upon the Cliffwater Direct Lending Index (“CDLI”), an asset-weighted index of approximately 13,000 directly originated middle market loans totaling $283B as of June 30, 2023. The CDLI assists investors in better understanding private credit as an asset class and to benchmark manager performance. The table below depicts the historical performance of these middle market loans.

Among the funds Chicago Partners focuses on are Cliffwater Corporate Lending (CCLFX), Cliffwater Enhanced Lending (CELFX), and Variant Alternative Income (NICHX). CCLFX annualized an 8.72% return since inception, CELFX annualized a 12.53% return since inception, and NICHX annualized an 8.95% return since inception. These uncorrelated investments significantly outperformed their benchmarks, with the Morningstar LSTA US Leveraged Loan Index returning 4.71% and Treasury Bills returning 2.44% in the same period.

The flexibility in debt structuring and repayment strategies distinguishes private credit from traditional fixed income strategies, making it an attractive option for investors navigating tight credit environments. Despite inherent risks, including potential defaults and lack of transparency, effective mitigation strategies, such as rebalancing and underwriting for downside scenarios, contribute to the resilience of private credit investments.

Some private credit investments may not be available to all investors. If you are interested in learning more about private credit or gaining access to highly-vetted private investments, you are welcome to reach out to one of our advisors.