Private credit’s appeal extends far beyond its illiquidity premium, experts have said, amid increasing competition from public markets.
The sector benefitted from the ultra-low-interest-rate regime after the pandemic, but higher rates have meant that traditional fixed income markets have been able to offer more attractive yields.
Industry stakeholders have told Alternative Credit Investor that large amounts of capital available amongst private credit funds and increased competition from banks, which have been loosening lending standards, are some of the root causes changing the landscape for investors.
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“When liquid alternatives start looking this good, the premium for locking up capital naturally shrinks, eroding one of the key advantages of the asset class,” said Tammy Davies, partner in the finance department of US law firm Morrison Foerster, who specialises in bespoke and complex credit arrangements.
Meanwhile, Daniel Haydon, analyst for equity strategies at financial research firm Morningstar, said that “the quantum of the impact is not yet known…but the directional effect seems clear.”
“The nature of the market at the aggregate is changing,” he added.
Still, the strength and resilience of private credit markets globally are underpinned by more than their illiquidity premium, points out Morningstar DBRS’ head of European financial institutions, Marcos Alvarez. “It is also important to remember that the yield of private credit assets is not only driven by the illiquidity premium but also by the credit risk premium, which remains substantial in this asset class.”
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Alvarez does not expect a material reverse in the flow of assets from private credit to the traditional banking sector in the next 12 to 18 months. He argues this is because banking regulators in most jurisdictions are seen to be reluctant to relax lending standards and because solvency requirements make it more onerous for banks to lend in certain cases, relative to private lenders.
“There is a secular movement of assets to private lending that goes beyond just loosening lending standards,” he added.
Morrison Foerster’s Davies agrees. She says the illiquidity premium “remains in areas that have always justified it – such as non-sponsored middle market opportunities, opportunistic credits and other esoteric investments that require more creative structuring, deeper underwriting, and greater appetite for complexity”. She argues that in these specific segments, investors are still rewarded “for providing capital where others are less willing or able to go”.
Moreover, the illiquidity premium within private credit also differs from sector to sector and region to region, says Evangelia Gkeka, senior analyst for fixed income strategies at Morningstar. “Private credit managers with a wide-ranging mandate can still find opportunities with an attractive complexity premium compared to public markets,” she explained.
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The increased interest from retail investors in private credit assets is, nonetheless, testing the market, notes Davies. “As managers work to attract retail investors, many are launching fund structures that aim to replicate the experience of a liquid product,” she said. “The very feature that once defined private credit’s competitive edge is being engineered away in the pursuit of new investors who seek the illiquidity premium but may not have the appetite for it.”
