5 min read 23 Oct 23
By the end of 2022, assets under management in private debt reached $1.5 trillion1 as the global search for yield saw investors continue to increase allocations to the asset class. Within the next four years, these assets are expected to hit $2.3 trillion2. Private credit in Europe is also a key part of this growth trajectory which, according to Preqin, is about a third of the $1.5 trillion universe. The complexity/opacity return premium is not the only driver of this exponential growth, increasingly investors are also allocating on the basis of diversification and yield stability.
Private credit, in our view, is essentially a corporate lending subset of private debt, but there are some fundamental differences between how it is approached in the US and Europe.
In the US, the private part of private credit often refers to the sourcing and trading mechanism of the corporate loan assets. If it happens directly and without any bank underwriting or involvement it is classified as private. This means typically the US definition of private credit excludes Broadly Syndicated Loans (BSLs) because, in the US, these are arranged and sold like high-yield bonds. They are daily traded, regulated, and their syndication processes and information provisions are public.
We think that the private classification should rather refer to the unlisted status of the investee companies and the status of the lender because in essence all lending can be private in Europe. Excluding leveraged loans from private credit limits corporate lending options while also reducing the opportunity set available by not including larger and more established private companies. Indeed, the European leveraged loan market alone is a $450 billion market3, and is often omitted from estimates of the wider private credit market size. Therefore in our view, the depth of the European private credit market is consistently underestimated, and we believe the true scope could be over $800 billion.
We see some US managers talk about private credit as a form of privatisation of the BSL and bond market processes. They celebrate diverting companies from the visible traded world. We believe Europe resists taking a rigid approach to private credit, including BSLs under the private assets umbrella. There is access to much more information than would be available in a public bond process, upfront and through the life of the investment.
In Europe, we think more symbiotically and consider what investors need from private credit, whether they are strategically or tactically allocated, whether they are held to maturity or seeking liquidity. This informs the portfolio construction and deployment approach to building a private credit product offering.
US private credit is facing a number of larger tail risks than Europe. US terminal rates are pricing higher than Europe, which means US borrowers have higher debt servicing costs to contend with. Fundamentals such as leverage and interest coverage ratios (ICR) are much eroded and point to a less robust capital structure for the US relative to Europe. The 20 largest US buy out deals from 2021 now have ICRs at about 2x4. These would have been the attractive bounce-back names from Covid which speak to a weaker, broader universe.
The US regulatory environment is more homogenous and borrower-friendly, while Europe is more fragmented with regional idiosyncrasies. This on the surface would seem like an advantage, but actually this has led to pervasive loosening of documentation standards within the US. As weaker credits have scrambled for funding solutions in this elevated rate environment a new trend to emerge in the US has been uptiering of new lenders and down-dropping of existing senior lenders. This is where borrowers seek new (read: rescue) financing from a small group of lenders and place them ahead of others in terms of priority of payments. This effectively pushes first lien lenders down the capital structure and ultimately leads to a lower recovery.
This has not emerged in force in European loans, owing to on average more simple capital structures, ‘white lists’ that preclude many vulture funds from loan syndicates, and the higher threshold for fair behaviour to all stakeholders encoded in company directors’ responsibilities. Europe has a culture and legal systems that impose heightened director responsibilities that would make some of the aggressive processes of the US legally intolerable.
When default risk is elevated, fundamental credit risk is heightened throughout the corporate world. Fundamentally, in corporate lending, performance depends on the company paying you back. Your chances of generating positive returns is improved hugely by maximising selectivity and information flow. Staying private side offers that chance of improved information flow due to a closer relationship with the borrowers and sponsors. This is particularly prevalent in Europe.
Ultimately the numbers speak for themselves, we have seen a consistent outperformance of European BSLs vs US BSLs across multiple market cycles, largely driven by the fundamental differences in these markets.
Many companies are electing to stay private for longer and private credit is a key part of financing these companies through their growth cycle. The key to building a stable portfolio is a diversified allocation of low correlated return streams. As private markets continue to evolve, we now see a broader swathe of investors ranging from institutional clients to individual investors, looking to capitalise on the return, stability and diversification benefits of private credit.
Whilst Europe has no business development companies (BDCs), a common means for US wholesale investors to gain exposure to private credit, there has been an emergence of complementary long term investment fund regimes in the UK and Europe, so called LTAFs and ELTIFs. Regulators have taken note of the economic gap that restricting access to private markets creates for both companies and consumers, and addressed this via these flexible structures.
Private credit was traditionally only available through closed-end funds. These more flexible structures are ultimately democratising the asset class, providing exposure to potentially stable, long-term and diversified incomes.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.