Are consultants recommending asset owners ditch private credit?
Concerns about private credit have been widespread as some lenders, such as Blue Owl, have faced difficulties. But consultants are not seeing any trepidation among their clients (Michael Nagle/Bloomberg)
Good morning. We return to private credit this week (but don’t worry, next week we’ll do something different - barring a complete collapse of the market).
There are plenty of opinions about what is going to happen in the private credit market but I thought it would be interesting to get some insights from investment consultants into the conversations they are having with their clients and what they are recommending.
Very few of the consultants I asked were willing to talk about this, so gold stars go to those who were.
Nick Cooney, a partner at LCP, said he had been having conversations with clients who were concerned about the negative consensus surrounding private credit.
LCP, for its part, has a low conviction underweight to direct lending but some of his clients - including some charities - were expressing “real interest” in the market.
He said: “Some of the endowments are being brave while others are fearful but are going full speed the other way and allocating to the riskiest strategies where they think they can get higher returns. That’s a play on the concern.”
Cooney said: “We have moved to a high conviction overweight to opportunistic private credit strategies. We think there are some interesting opportunities.
“The market is not homogenous. We have more concerns about some of the upper mid-market where covenants are already very loose. There’s also a lot more competition with banks.
“The returns you are getting are compressing a bit, or at least not going up when there's a lot of macro uncertainty.”
Cooney said he was more optimistic about the lower mid-market because of the relative lack of competition, but it was important to invest selectively.
Constantine Braswell, vice president in Callan's alternatives consulting group, said selling out of private credit was not a subject which his clients had been bringing up and he said they were not “freaking out”.
Like Cooney, he said some of his clients were even discussing buying into certain parts of the market.
He said: “I wouldn’t say anyone is leaning in but neither are they not committing this year. No one is slamming on the breaks.”
Braswell said: “Myself and our team certainly do have concerns around private credit but more specifically around direct lending and the absolute amount of capital which has flooded the market. I attribute that to retail investors.
“But there’s always opportunity. Our comments and the sentiment of our limited partneris that it feels now is the time to commit to some distressed or opportunist funds even though there hasn’t been a huge blow out yet.”
James Lewis, UK chief investment officer at Mercer, said he is recommending downside protection such as strong covenant packages, portfolio diversification and active monitoring of investments.
He said: “Individual credit selection will become increasingly important as company outcomes experience more dispersion than in the past.”
Vijay Padmanabhan, managing director for private credit at Cambridge Associates, said he encourages his clients to treat the asset class as a “core allocation” and therefore they are actively positioned to use it in their portfolios.
He said: “We are paying close attention to areas where the credit underwriting and documentation were set against a more benign interest rate backdrop. Our emphasis is less on broad allocation shifts and more on maintaining exposure selectively through manager quality and vintage diversification.”
So what are the base case scenarios for how this plays out?
Lewis said: “We expect software repricing to act as a catalyst for, and are seeing early indications of, broader spread widening as liquidity tightens and risk premiums increase.
“We believe this repricing is healthy for the private credit market and will create opportunities for investors with sufficient liquidity and a long-term horizon to capture value.”
He expects the stress to be concentrated in vulnerable sectors such as software rather than being broad-based.
Cooney said: “Our base case is that this isn’t the end of the world. It is leaning to a more stagflationary situation.
“We think there will be fall out and some managers who have been influential will struggle and slowly disappear
“There will be others who do very well out of this and will use that to raise more money.”
Braswell agreed this would thin out the ranks of the managers working in this sector and he pointed out there was “a lot of bad behaviour”, including masking defaults and losses, but he was expecting things to come to a head in the second half of this year.
He said: “I would expect defaults and losses to pick up over the next couple of quarters.
“I think it’s tough to say that every lender you see now is going to survive
“While it will make my job harder in the short term, it will make it easier in the long term because it has been difficult to differentiate some of these direct lenders.”
