Private credit’s push into the wealth market, leading to increased flows, is risking eroding returns, according to a new report by Adams Street Partners.
The group’s private credit team, including head of private credit Bill Sacher, noted that the rapid scaling of business development companies and life insurance general accounts have put increased pressure on investment teams to deploy capital.
This can compromise underwriting standards and credit selection, the authors of the note said, and lead to sub-par returns.
“The natural solution to address this risk is self-regulating asset growth, but publicly listed private credit managers have little incentive to do so given their stock prices are highly correlated to fee-earning asset growth,” they noted.
Calling the publicly traded private credit managers “hyperscalers” Sacher, head of investments Jeffrey Diehl and head of credit underwriting Fred Chung wrote that they “may be propelling their investors on an undetected rise of forced deployment”.
They suggested that institutional investors should measure the total annual deployment growth of their private credit managers and assess manager alignment of interest.
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The authors estimated that the managers of the four largest perpetual business development companies must, on average, invest $23bn (£17bn) annually to keep their funds fully invested, including target leverage and current annual net inflows. And the largest private BDCs, they said, must invest $43bn a year, representing 27 per cent of the annual US direct lending market.
“At this percentage of the market, it can become challenging to produce top-quartile returns and the risk of investing some capital in lower quality assets, which are more likely to generate median or worse returns, can become quite elevated,” they noted.
The team also said that they observed and erosion of pricing and terms in large direct lending deals, which have to compete against broadly syndicated loans. They have also seen lending to companies with highly cyclical, concentrated or declining revenues take place.
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