Why We See Opportunity in Private Credit

Given the current stress on the banking sector, we strongly feel that private credit funds, especially middle-market direct lending platforms, can potentially offer attractive investment opportunities for suitable investors.

Christian Salomone

Chief Investment Officer

christian.salomone@ballastrockpw.com

The collapse of Swiss banking giant Credit Suisse, California-based Silicon Valley Bank and New York’s Signature Bank are causing a significant tightening of already stressed credit markets. Even before the recent banking crisis, falling asset prices and recession fears had caused banks to reduce their loan portfolios and restrict lending practices.

Now, we expect banks to hold more cash on hand to cover customer withdrawals, which means less money to lend into the economy. This market contraction means loans are harder to source and significantly more costly, even for strongly collateralized middle-market companies. Direct lenders are perfectly positioned, with hundreds of billions of dollars of dry powder to step into this void, providing a solid source of income and excess returns for their investors.

Direct lending is a subset of the private credit market in which borrowers obtain loans directly from institutional investors or specialized lenders, bypassing traditional banks. Borrowers typically pay floating rate coupons, subject to floors should rates decrease.

Furthermore, these loans are primarily “senior,” meaning lenders have repayment priority over other creditors and the loans are secured by assets and/or recurring revenue streams. Direct lending platforms offer more flexible terms and quicker underwriting processes compared to traditional bank financing, with customized structures, covenants, and repayment schedules that can better suit the needs of borrowers. Middle-market companies use direct lending platforms to finance acquisitions, pay for capital expenditures, provide working capital, or for other needs.

Risk and Return Across Fixed Income Asset Classes

Source: Morningstar, Cliffwater Direct Lending Index, as of December 31, 2021. Volatility is measured using standard deviation. Morningstar computes standard deviation using trailing quarterly total returns for 15 years. All of the monthly standard deviations are then annualized and the volatility is expressed as a percentage.

As the previous chart showed, during times of corrections and contractions in traditional credit markets, private credit funds can demand higher yields, while offering less leverage (loan to value) with more favorable loan covenants to the lenders. This dynamic means better risk-adjusted returns for investors. Historically, U.S. direct lending returns have been higher than returns on high-yield bonds and leveraged loans, but with lower volatility.

Furthermore, U.S. direct lending platforms have historically generated average annualized returns of 9.4%, compared with 5.7% for high-yield bonds and 4.3% for leveraged loans.

As of March 31, 2022. Source: Bloomberg US Investment Grade Aggregate Bond Index. Credit Suisse Leveraged Loan Index, ICE BoFa HY Index, Cliffwater Direct Lending Index, Bloomberg, Please refer to the end of the document for index definitions.

Unlike high-yield bonds and leveraged loans, which are commonly utilized by more highly leveraged companies and carry a higher risk of default, direct lending investments are typically made to more creditworthy borrowers.

Better credit quality means lower defaults/loss provisions making direct-lending returns much less volatile. Volatility of returns is also reduced by diversifying borrowers by size, industry, and geographic location, while loan sizes are typically capped at no more than 1%-2% of the total portfolio.

Due to stress in the capital markets, private direct lending platforms are uniquely positioned to demand higher spreads, lower leverage, and stronger covenants when providing liquidity to even well capitalized middle market companies. Over the next 12-24 months, we expect private credit funds to deliver outsized risk adjusted returns to their investors.

Of course, suitability for any investment opportunity is relative to each investor's personal risk tolerance and financial objectives. As such, we strongly encourage you consult a fiduciary.

Have questions? Contact your financial advisor or our team members at Ballast Rock Private Wealth at ir@ballastrockpw.com

Disclosure: Past performance is not indicative of future results. The opinions expressed are those of Ballast Rock Private Wealth and should not be taken as financial advice or a recommendation to buy or sell any security. BRPW is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in BRPW’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Ballast Rock Private Wealth portfolio. Material presented has been derived from sources considered to be reliable. but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation, or an offer to buy. sell or hold any securities, other investments or to adopt any investment strategy or strategies.