Investment

Private credit well placed to insulate against inflationary headwinds for family offices

As inflation spikes to its highest level in a generation, family offices need to work hard to protect their wealth against its corrosive impact. 

One investment opportunity that could provide sanctuary is private credit, a mainstay of corporate America – where institutional financing of businesses is far greater than bank financing – and a growth sector in Europe.

Moody’s estimates that global private credit has doubled in size over the last five years to approximately $1 trillion. In Europe, the annual growth rate for direct lending has been 30% for the past five years, according to Deloitte.

At a time when public markets and PE are under pressure, private credit is a standout asset class offering positive returns with good protection against the key downsides of a rising rate environment

The demand for loans has increased exponentially according to Stephan Caron, head of European mid-market debt at BlackRock. He points to a recent report saying that 50% of mid-market buyouts in Germany are being financed by direct lending, against 16% in 2016. 

Investors in search of inflation proofing can access corporate floating-rate loans, or distressed debt. Or they can tap into similar deals for physical assets, such as real estate or aircraft, potentially at a premium rate. 

Morten Kielland, co-founder of Key Family Partners, is interested in private credit. His multi-family office allocates 7.5% allocation to it. He gets loan deals through his firm’s bank and expects a return of 10%.

The bridge loan market has expanded in the wake of the pandemic according to Robert Stafler, co-founder and chief executive of Fintex Capital, an adviser to family offices.

He says: “If a ratings agency were to look at what a successful private credit fund does, they would conclude it is more rewarding, from a return perspective, and less risky compared to, for example, high yield bonds. 

“In a high yield portfolio, if you’re looking at 6% annual return, with a private credit portfolio you can achieve 9% or 10% per year, net of costs.”

This premium reflects the illiquidity of each deal, but also its complexity. 

Liquidity in private credit can be better than one thinks, whereas liquidity with listed securities can sometimes be worse than you might expect. Stafler says: “A private debt investment can be complex because the lender identified risks and he may choose to manage those. 

“This can make the loan a bit more complex. Often complexity means not more risk, but rather better risk management. We all prefer simplicity over complexity, but we also prefer complexity over excess risk.” 

As interest rates rise over the coming period to contain inflation, this will further increase the attraction of senior floating-rate loans. 

It will favour private credit investments over private equity, as higher interest rates increase debt servicing costs for portfolio companies.

Reji Vettasseri is Lead Portfolio Manager for alternative funds and mandates in private markets at Decalia Private Markets.

He says: “At a time when public markets and PE are under pressure, private credit is a standout asset class offering positive returns with good protection against the key downsides of a rising rate environment. 

“On the upside, credit returns naturally benefit from higher rates. Robust structuring protects against macro risks and, unlike bonds, hold-to-maturity private loans do not suffer mark-to-market volatility.” 

Wealth adviser Pictet recently highlighted the importance of private debt and inflation-linked bonds in its May 2022 strategy report. 

“With higher inflation, their high real returns and suitability to active management also warrant their inclusion in strategic allocations. Forming an integral part of any endowment approach to investing, private debt and inflation-linked bonds should improve the real returns of a strategic asset allocation.” 

Countries like the UK, which account for the majority of direct lending deals in Europe, remain attractive but as family offices look more closely at private credit they should remain cautious that there are no free lunches in the investment world. 

Alternative lenders chasing the pool of corporate borrowers has, in recent years, led to a dilution of investor protection, through covenant-lite deals, and a willingness to take on more risk. Lending to companies with stretched margins in a higher interest rate environment is not ideal. 

“This is a tricky time, where many corporate borrowers need to refinance their existing facilities and large parts of the capital markets are closed. Investors need to be careful but now is an excellent time to be in private debt generating predictable income,” says Stafler. 

To avoid crowded parts of the market, firms like Fintex seek out smaller, more ‘quirky’ opportunities; that is, incremental complexity as opposed to incremental risk. 

“We invest in specific arenas within speciality finance, a market overlooked by many lenders. We focus on deals requiring less than £15m, which carry some complexity.”

Manager selection is vital. Key questions to consider are: How large is the fund manager? How much dry powder –  – un-invested capital – needs to find a home? What is the credit selection strategy? Have managers found a source of private debt where there is limited competition? 

Much will come down to the quality of managers’ underwriting and their understanding when to walk away from the wrong deals. Even a modest year-on-year increase will make an impact on borrowers, while interest rates are low. But floating rate loans to high-quality companies with stable revenues and growth opportunities should be conducive to strong returns.  

Portfolio construction also matters, according to Stafler “Normally, if the underlying is safe, like residential mortgages, we might prefer to be in a mezzanine position, whereas if the underlying asset is more complex or quirky – i.e. financing Uber drivers – we might structure a senior loan facility.” 

 

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