Considering Private Credit? The Value of a “Cross-Silo” Approach

Introduction

The expression private credit has devolved into a catchall term but is most closely related to the broadly syndicated loan market. However, there are multiple channels borrowers can potentially access when trying to raise capital. Wise borrowers make relative value assessments across various capital sources, including the syndicated bank loan market, the high yield and convertible bond markets and even structured credit. Therefore, we believe it’s important to understand private credit in relation to broader credit channels and suggest investors take a wider, ‘cross-silo’ approach to understanding value in the credit space.

Extending Credit Can Be Competitive

What Is the Cheapest Funding Source?

In this article, we will examine the differences and similarities between private and public credit markets, the benefits and risks of private credit vis-á-vis the public credit market, and how we at Thornburg suggest allocators approach this evolving market.

There are significant similarities between the public and private credit markets. Among these are debt structure and the credit analysis that must take place. Both public and private credit securities can feature floating rate debt deals with a similar structure and corporate credit underwriting process.

But there are important factors that differentiate private credit:

• Direct negotiation – the borrower and the non-bank lender typically negotiate these deals directly, cutting out the middle person.
• The deals are typically very compact, small club-like deals – they may only have three to five investors or even a sole lender, meaning the loans are highly illiquid and, in many instances, do not trade. But in recent years, the size of private credit deals has increased markedly.
• Historically, deals primarily derive from middle market private companies that do not choose to access or cannot access other credit channels. (In recent years, the private credit market has increasingly shifted to compete directly with public markets for larger corporate deals.)
• Locked-up funding structures – private credit deals typically feature funding structures with long-term and sometimes permanent capital because the underlying assets are illiquid.

Risk Profiles: The Fundamental Differences Between Private and Public Credit

Historically, private credit deals skewed to fund leveraged buyout (LBO) transactions that are riskier and more complex than many public credit deals. These transactions often involve operational restructurings, such as carve-out transactions and merger and acquisition dispositions during the deal’s life, further adding to their complexity. Additionally, private credit borrowers have typically been smaller and lower middle market companies, although, as we mentioned earlier, the size of individual deals has increased markedly in recent years. Private credit deals have now migrated down the capital structure, with many deals lower in priority than 1^st lien debt. Additionally, because most private credit deals feature floating rates, a rising rate environment raises concerns about borrower creditworthiness as worries mount about whether free cash flow will meet the higher coupon payments.

The Option Value of Liquidity

Other fundamentals that differentiate private and public credit markets are their liquidity, volatility, and transparency profiles. Market liquidity exposes a significant factor differentiating private and public credit. As mentioned earlier, private credit lenders can’t efficiently trade in and out of positions. Moreover, these deals’ lack of transparent pricing severely limits available information about the private credit position. If an investor wants to exit a private credit position, it requires a deep understanding of the loan to develop a bid or – if you’re lucky – an eventual buyer on the other side.

Short, Sharp Selloffs Create Opportunities for Active Investors in Public Credit Markets

High Yield Index Option Adjusted Spread and Default Rates

Source: Bloomberg, JP Morgan

Looking at the volatility in the past decade, we’ve had short, sharp selloffs or outright dislocations in 2016, 2018, 2020 and 2022, which were opportunities for active public credit investors to add value. But suppose your portfolio is illiquid, even frozen (because of long lockup periods typically included in private credit covenants). In that case, it’s exceedingly difficult to rotate private credit positions into new opportunities that may provide exceptional entry points during times of volatility and dislocation in the credit markets. The last element is transparency. Transparency into underlying credit performance is unavailable because rating agencies rarely follow private credits and do not have a wide market following. In addition, prices are infrequently marked, disguising the potential risk of impairment and volatility relative to public credit markets.

Liquidity, volatility, and lack of transparency all add to the difficulty of quantifying risks and properly allocating capital resources. As a private credit investor, these risks can be amplified, and you don’t fully know if you’re carrying too much or too little when the markets move. As a result, the option value of liquidity increases with volatility.

Public Vs. Private Credit: Assessing Relative Value

Private credit transactions provide value to lenders through speed and certainty of close. They also allow some creative structuring and perhaps the ability to stretch in the investor’s favor concerning specific terms of the deal. Many banks are capped by regulation regarding what kind of deals they can take on their balance sheet and commit to in terms of leverage, the types of transactions and the riskiness of the transactions. Private credit lenders offer an alternative to capital-strapped banks that may face even higher capital requirements following last year’s collapse of several regional banks in the United States.

Remember that private credit transactions are primary floating rate loans with little duration and callable structures. When credit spreads tighten in good times, private credit may get called as companies look to refinance into less expensive debt financing. During troubled times, these loans not only experience credit spread widening but returns are hampered as short-term rates tend to go down. That leaves a double hit: one from the coupon declining and one from credit spreads widening.

What Should Investors Look At

When assessing private credit deals, we feel there are specific metrics that investors need to examine closely for what we consider warning flags. Risky behavior flags to watch for include:

• Non-cash income – companies that are unable or unwilling to make cash interest payments are usually weaker credits than companies managed in order to make cash interest payments. A private credit portfolio with high non-cash income may be weaker than one with low non-cash income. There are several ways to reduce the mix of returns from cash coupons, such as increasing PIK (payment-in-kind), OID (Original Issue Discounts) or warrants (for equity).
• Marks – we touched on marks being essential to transparency. Many private credit lenders do not have a reliable process for marking their portfolios in a timely manner.

We also look at undifferentiated sponsor deal flow flags that include:

• Deal sizes – loans over $250 million can be broadly syndicated or funded alternatively in the public bond markets. If larger deals comprise a large percentage of the portfolio, we must question whether the deal flow is differentiated.
• Solo or not – if the lender solely holds a deal, it is likely less well-followed credit and perhaps indicates less competitive deal origination and differentiated deal flow.
• Niches – specialization in the underwriting and origination within niche industries indicates differentiated, less competitive deal flow. We want to see managers and originators with strong track records in less competitive niches.

At Thornburg, we think allocators can benefit from exposure to both public and private credit. But rather than looking at public vs. private credit as entirely separate entities, we encourage allocators to take a ‘cross-silo’ approach, making sure to leverage expertise across public corporates, equities, and even securitized credit to understand the best risk/reward across the credit space.

Think Differently About Credit Analysis

Break Down Investment Silos

Our investment approach is consistent with this thinking, breaking down the vertical investment silos that artificially separate equities from fixed income and other assets. We openly leverage resources across different sectors and asset classes to uncover the best relative value in credit. We believe investors can extract additional information reaching across the investment silos rather than limiting input about private credit decisions to the private credit analyst alone.