Sam Adams, Portfolio Manager, SR Alternative Credit, LLC
February 1, 2023
If you like uncertainty, 2022 was your year. Supply-chain logistics were log-jammed. Inflation caught fire, leading the Federal Reserve to impose large-scale rate hikes. Increased rates drove housing values sharply down in most markets. Tech took a particular beating, as the stock indexes went south generally and crypto imploded. War broke out in Ukraine and oil prices went through the roof. To top it off, a recession seems possible in 2023. All these developments have left many investors concerned. They are looking for a safer harbor for their investments during these stormy seas. We believe private credit offers better principal security than equity investments, and we think it offers an opportunity for attractive returns in 2023 and beyond. Here’s why:
A hedge against inflation
Many private credit investments today are floating-rate loans. Adjustable rates provide an important hedge against inflation, which is the main risk in the near-term economy. The yields from floating-rate loans are usually some of the highest among fixed-income instruments. Floating rates in these loans usually reset monthly or quarterly against common benchmarks, preserving investment value. Most such loans are structured with interest-rate floors so that when inflation finally abates returns will be protected. These factors afford investors a more attractive fixed-income return than can be found outside private credit today.
Reduced market correlation
No investment is immune from market downdrafts. But private credit investments, particularly in real and financial assets, are largely uncorrelated to the market. There are a number of reasons why. First, private credit assets are not subject to mark-to-market volatility. They typically have a longer tenor, which also flattens market effects. Further, asset-based loans are ordinarily collateralized with assets that are less subject to price volatility. They are also subjected to loan-to-value criteria that naturally hedge against market volatility as well as the potential for change in the value of the collateral. Collateral top-up and reserve requirements provide further insulation against macro developments and market fluctuations. As we see it, all these characteristics provide investors some shelter against current market uncertainty.
Asset security = Principal protection
Private credit transactions that are asset-based loans provide collateral protection. With prudent advance rates (loan-to-value) secured lenders can protect principal investment against deterioration or loss, even in a borrower default situation. Equity investments are fully exposed, as the last year in the stock market has shown.
Bespoke transaction terms mean tighter asset control
Private credit transactions are individually negotiated and tailored. This allows lenders to adjust terms to take into account each borrower’s unique circumstances and the special features of each industry. This yields a closer understanding of each borrower, promoting properly-structured financial and other covenants, and stronger reporting for these transactions. Investors benefit because there are typically tighter controls over assets in private credit than in the public market. These private credit transaction controls are particularly important in this market cycle, where off-the-rack credit instruments aren’t tailored to today’s unique risks.
Attractive returns from an underserved market
Private credit—particularly in the middle- and lower-middle markets—often affords investors attractive returns because these borrowers are underserved. Typical coupons range from 7% up to 15%. While private lending has grown substantially in the last ten years to meet borrower demand for credit, the economic uncertainty and market turbulence described above are only going to stoke the need for more privately-sourced credit, and this demand may increase returns. Why is that? The leading factor is increased rates. As rates go up, banks’ lending criteria will tighten, reducing the amount of credit available for small and medium-sized businesses. Solid companies previously welcomed by banks a year ago will now need private credit. This will be particularly true for companies seeking loans in the range of $15-$50 million, where the ratio of loan effort and risk to investment return doesn’t work well for most banks. But private credit lenders welcome smaller scale and higher complexity because these features, if properly structured and managed, yield higher returns.
Private credit for investors in 2023
We believe that private credit will be an attractive option for investors this year and beyond. Investors may want to consider some of the following features of private credit:
- Private credit offers a hedge against inflation
- Investments are usually uncorrelated to market performance
- Private credit typically provides greater potential for protecting an investor’s principal than equity investments
- Transactions are tailored to each borrower, creating tighter lender controls
- Private credit offers strong return potential with mitigated risk
Interested in learning more?
The SR Alternative Credit team are specialists in middle- and lower-middle market private credit. They focus on senior-secured asset-based loans ranging from $10-$50 million. Typical loan coupons range from 9% to 15%. They lend to a diversified group of industries and borrowers on term and revolving bases. Investors benefit from exposure to a diversified portfolio of private credit investments.
The views expressed are those of Spouting Rock Asset Management (“SRAM”) platform, as of February 1, 2023, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurance that any SRAM strategy or investment will achieve its objectives or avoid substantial losses. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict, or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.