Private credit has become a popular asset class among investors, as yields are relatively high and default rates low. But has it become a bubble? MLC Asset Management’s Dan Farmer provides his thoughts
Private credit has become an attractive asset class in recent years, as banks stepped away from the sector in the wake of the Global Financial Crisis, resulting in higher yields for those that were still willing to lend.
According to figures from the International Monetary Fund (IFM), the global private credit market reached a size of US$2.1 trillion last year when combining assets and committed capital. This stellar rise caused the IFM to voice concerns about the potential of systemic risk arising in the financial system.
“Private corporate credit has created significant economic benefits by providing long-term financing to corporate borrowers. However, the migration of this lending from regulated banks and more transparent public markets to the more opaque world of private credit creates potential risks,” the IFM stated.
“Valuation is infrequent, credit quality isn’t always clear or easy to assess, and it’s hard to understand how systemic risks may be building given the less than clear interconnections between private credit funds, private equity firms, commercial banks, and investors.
“Given that this ecosystem is opaque and highly interconnected, and if fast growth continues with limited oversight, existing vulnerabilities could become a systemic risk for the broader financial system,” it said.
On Wednesday 24 July, delegates at the MLC Asset Management Investment Forum also displayed some level of discomfort with the strong growth of the sector, drawing parallels to the rapid growth and subsequent shut down of mortgage funds, and asked Dan Farmer, Chief Investment Officer of MLC Asset Management (previously known as Insignia Financial) a direct question:
Is private credit in a bubble?
Farmer acknowledged that the asset class has attracted strong inflows and as a result many more fund managers have opened private credit strategies. Not all of them are high quality, he said.
“If you just look at the number of managers that have opened up… I’d say around 10 years ago, there might have been four or five private credit specialist managers. Today, I think there’s over 200. So, there are a lot of tourists.
If you just look at the number of managers that have opened up... I'd say around 10 years ago, there might have been four or five private credit specialist managers. Today, I think there's over 200. So, there are a lot of tourists
“There are a lot of funds saying: ‘Gee, there’s plenty of money in private credit. Let’s open up a private credit fund’. I’m wary of that,” he said.
But he also said the private credit strategies have been able to produce strong returns and his team has been increasing their exposure to global private credit.
The key to investing in this sector is to find experienced managers, who have been investing in this space before everyone jumped on the bandwagon.
“When we go into private credit, we want really established managers that know the space, have got credentials, and they really know how to do the bottom-up work on the quality of the private credit,” he says.
“[We want to] make sure they know exactly what they’re buying. It’s almost like equity analysis; they really know their businesses.”
So is private credit in a bubble?
Judging from the amount of money flowing into private credit strategies it would be wise to be cautious when investing into the space, Farmer said, but he also argued that the yields that managers are able to generate indicate that private credit is still good value.
“Yes, a lot of money is coming to private credit, that’s one side of the balance sheet. The other side of the balance sheet is the traditional banks, and in the US case, [you have] the regional banks, where a lot of capital credit is withdrawn,” he said.
“The traditional funding sources disappear, and in good, efficient capital markets that means the return goes up.
“So, I think the litmus test of that is, if there’s too much capital coming in…, those returns are being crushed, and then you’re not getting rewarded for the risk you’re taking.
“We’re still seeing good returns from really high-quality credit,” he said.
But Farmer also said his team had been insulating the portfolio against a significant drawdown by adding long duration instruments, such as government bonds and investment grade credit.
Although Farmer expected the chance of a soft landing to be around 70 per cent, he said long duration instruments provided some insurance against a potential recession.
“We think duration is useful now. If we see a sell off, if we’re wrong and … you get a recession, then people are rushing up to bonds. So we quite like that duration as an integral protection in our portfolio. But we’re getting paid to hold that protection. We’re getting 6.1 per cent yields on that All Maturities bucket,” he said.
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