This is the fourth in a series of articles in our special report on alternative investments in Canada. To see all the articles, click here.
Despite its dull title, a Bank of International Settlements report called The Global Drivers of Private Credit contains valuable information for advisors and investors who are considering allocations to this fast-growing investment category.
Private credit refers to non-bank credit provided by specialized investment vehicles or funds to small or medium-sized non-financial firms. They are typically negotiated directly between borrowers and lenders. Private credit funds typically offer higher yields than are available from more liquid, public investments while attempting to also deliver higher overall returns.
Industries and businesses that find themselves underserved by the traditional banking sector appreciate the entrepreneurial nature of private credit lenders who can tailor transactions to their unique situations. Private credit loan agreements can offer bespoke covenants and be negotiated much more quickly. Adjustments to terms can also be negotiated to align with changing industry and business dynamics.
Although growth in private credit has been a global phenomenon, the report notes that “the footprint of private credit is larger in countries with lower policy rates, more stringent banking regulation and a less efficient banking sector.” Given that Canada ticks all three of these boxes, it is no wonder that private credit growth in the Canadian market has been much faster—and has already provided some high-profile mishaps and unfortunate losses for investors.
Armed with more information on the structure and risks in the private credit space, we hope that investors can enjoy the higher income and returns available while also mitigating losses.
Experimenting with liquidity
As the private credit fund industry emerged over the past 20 years, the main source of capital was institutional investors with long-term investment horizons and low liquidity needs. These investors were comfortable with the typical 5- to 8-year lock-up periods that provide extremely limited—or even no—liquidity. This allowed funds to match the life cycle of the fund commitments to the average maturity of their loans, which mitigated liquidity risk.
The desire to attract retail investors into private credit funds, however, has seen fund managers experimenting with structures that allow investors to regularly redeem a portion or all of their fund holdings. Unfortunately, the liquidity promised by these retail funds creates an inherent and important mismatch between the fund’s loans and its investors.
As many Canadian private credit investors have already learned, this fundamental mismatch can create liquidity risks, causing a fund to suspend distributions and limit redemptions, or “gate” a fund. These situations tend to occur during market dislocations, when investors may want to reduce the overall risk in their portfolios and obtain greater access to cash.
The inherent liquidity risk in private credit is best mitigated by portfolio construction and diversification, and ensuring that the fund loan agreements demand real cash interest payments from their borrowers. With respect to portfolio construction, the easiest way to avoid an unwanted liquidity squeeze in a portfolio is to not expect liquidity from higher-yielding private credit allocations. It is best to consider these investments as illiquid and allow the managers to properly match investor and loan liquidity. To offset this illiquidity, investors need to have allocations to lower risk strategies that provide lower yields but ensure daily liquidity.
Diversification across differentiated private credit strategies, industries and geographies also helps to protect liquidity as many sector, industry or geographic-specific risks are offset by other investments.
Lastly, and maybe most importantly, make sure that your fund diligence reviews the real cash yield available to investors. Too often we see that private credit loan agreements allow for “PIK” interest, or “payment-in-kind,” which means that cash interest is not being paid. The outstanding loan amount simply increases with each PIK payment.
With no real cash interest coming from the borrowers, how can a fund pay cash interest and provide cash liquidity to investors?
Concentration vs. diversification
Industry specialization leads to elevated levels of concentration in typical private credit funds, which results in benefits but creates potential risks. Enhanced levels of industry knowledge and deeper understanding of industry-specific borrowers creates the ability to better underwrite, monitor and manage loans.
However, this also leads to confidence—potentially overconfidence—that can lead to the provision of better terms or more capital than other lenders. Investors can benefit from this industry-specific knowledge but also need to understand the concentration risks with respect to portfolio construction within their credit portfolio and across their broader portfolio.
Diversification in private credit also needs to be developed appropriately. This normally means having several private credit investments with teams that specialize in certain industries or loan types. Many Canadian private credit pools provide equity-like loans to businesses across very differentiated industries with vastly varied risks. A successful investment team requires in-depth knowledge on each company and industry to which they are lending.
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It is exceptionally hard to have sufficient expertise in enough industry verticals to build a diversified portfolio. Even if this were possible, there are also important inherent risks in portfolios that are Canadian-only—need we look any further than the turmoil caused by the Trump tariffs?
The best way to manage concentration risk is to manage bet sizes and focus on manager-level diligence. When allocating to a sector-specific or niche credit strategy, always ensure that the portfolio allocation is appropriate and that the manager has significant and demonstrable industry experience.
When thinking about diversification within your private credit portfolio, it is appropriate to start with an anchor position with a large, diversified, global private credit manager who can ensure strong underwriting across numerous industries and strategies while also providing good geographic diversification. Beyond this core position, add differentiated fund positions across a few niche strategies to provide enhanced returns at reasonable levels of incremental risk.
When looking at niche strategies, it is also important to consider whether you are duplicating risks or strategies existing in your equity portfolio. Private credit can offer equity-like downside risks, so ensuring cross-asset industry and geographic diversification is important here as well.
Credit risk and returns
The Global Drivers of Private Credit report also notes “that banks’ funding advantage has substantially narrowed since 2010” and “private credit’s growth has therefore been bolstered, at least in part, by a relative improvement in its funding cost.” Given that the funding cost of a private credit fund can be directly connected to the eventual return of an investor, this comment highlights the crucial point that the excess return demanded by private credit funds has consistently fallen over the past decade.
Investors must always consider whether taking the higher credit risk in private credit is worth the increased risk and related illiquidity. This dynamic is more difficult to manage for retail investors as they may read this as suggesting that it is best to seek out the highest returning strategies that may be taking on too much risk.
Due diligence, portfolio construction and manager selection are the best tools for mitigating this risk. The first diligence question on a private credit allocation should be whether the credit and illiquidity risk are worth the expected enhanced return provided by the investment. There are times when the liquid, public markets provide sufficiently good yields and taking on the illiquidity of private credit is not worth the risks.
The Moody’s Seasoned BAA Corporate Bond Spread is an important indicator of whether investors are being well compensated for the credit risk they are taking. Over the past five years, the excess returns generated for taking credit risk have compressed from ~3.5 per cent to a low of ~1.5 per cent and are currently at ~2 per cent. This means that the average BAA-rated bond is delivering a yield of about 6.3 per cent, or 2 percentage points higher than the U.S. Government 10-year bond. Private credit investors need to make sure that the loan-book of their fund managers can deliver returns well above this level.
It is no surprise that the demand for higher-yielding private credit opportunities corresponded with a decade of sustained low interest rates from 2011 to 2021. As most investors know, longer-term interest rates fell steadily from 1981 to the COVID pandemic lows of 2021. As measured by the US 10 Year Treasury bond, late 2011 saw the US 10-year yield fall below 2 per cent for the first time since World War II. From November 2011 to the 2021 COVID lows, the US 10 Year Treasury yield averaged about ~2 per cent.
With a lack of decent yield opportunities in government bonds and other public funds, investors chased higher yields and the related higher risks in the private credit market to generate the necessary yield for their portfolios.
Now that this era of compressed yields seems to be behind us, reasonable returns are now available in government securities and other liquid yield options. As such, portfolio construction is an important consideration here as investors should seek to increase private credit allocations when they are well compensated to do so, and lower allocations when they are not well compensated, or when lower risk solutions can fulfill the yield needs of their portfolios. Private credit should be looked at as a dynamic portfolio allocation within the context of a broader core portfolio invested in liquid, lower-risk yield solutions.
Other considerations
When weighing an allocation to private credit, here are two other important considerations:
Transparency – borrower and structuring: Borrower quality and well-structured loan agreements are critical to the success of a private credit fund. Many private credit strategies have large exposures to individual businesses and strategies. Beyond providing high levels of transparency on the borrower and on loan collateral, private credit funds should also provide transparency on how their loans are structured. Well-structured loans with adequate and pertinent downside protection should provide greater confidence to investors. Most importantly, good private credit managers will provide high levels of transparency on the funds’ borrowers and on the loan structures. Without this transparency, the risks are simply too great to make an allocation.
Loan-to-value and coverage: It is always critical to understand how your private credit manager underwrites his or her investments. Beyond the important step of understanding the quality of the borrower, we can look to specific measurements like loan-to-value (LTV) and coverage ratios to evaluate the level of potential downside protection. LTV is a good measurement to understand potential collectability of a loan in a challenged, downside scenario. High LTVs lead to low recoveries when macroeconomic situations deteriorate. Low LTVs offer the potential for full recovery of a challenged loan, even if it may take more time to collect on the obligation. Because interest payments—actual, real cash interest—are a critical aspect of a successful, performing loan, the coverage ratio is another critical measurement. It is important to ensure that the operating income of the underlying asset is well above interest charges on a loan.
Key definitions:
Coverage ratio: Measures a company’s ability to service its debt and meet its financial obligations, including its interest payments and dividends. Coverage ratio = Net operating income / debt service
Loan-to-value (LTV): Expresses the ratio of a loan to the value of the underlying asset. Loan-to-value = Loan amount / asset value
Conclusion
Private credit is a fast-growing sector of the market that is new to many retail investors and advisors. Although it can provide equity-like returns with lower levels of volatility, many important risks exist. Before making an allocation to a private credit strategy, invest significant time and diligence on the managers and funds in the space.
Investors will find many interesting and well-warranted strategies, but also many strategies and managers to be avoided. Canadian retail investors have already been negatively impacted by exposure to some of these strategies and managers. However, the benefits and returns of many private credit strategies are well worth the risks.
Private credit strategies
Direct lending: Extends covenant-heavy, floating-rate loans directly to companies and relies on cash generation from firms’ regular operations (“cash flow lending”) instead of collateral.
Mezzanine loans: Extending junior or subordinated debt to larger companies, often with equity participation rights.
Asset-based lending: Loans with hard assets as collateral, such as real estate, infrastructure or aircraft.
Distressed loans: The acquisition of troubled fixed-income assets—such as non-performing loans—in the secondary markets at meaningful discounts.
Factoring loans: Working capital loans with accounts receivable as collateral.
Keith McLean, CFA, MBA is a CFA Charterholder and holds an MBA from Dalhousie University. Keith is the President of Cabrasuke Inc. and a Partner with Chamberlain Family Office Advisors. With over 30 years of experience in risk management, equity investment analysis and portfolio management, he has experienced numerous market cycles that have allowed him to develop and expand his expertise while staying consistent to his long-standing investing principles. He has held senior investment and executive positions with several leading Canadian investment management businesses. His broad experience covers public and private asset classes as well as fundamental and quantitative investment strategies. Most recently, Keith helped a family office develop and grow an investment management platform. Beyond his work with Chamberlain, Keith has been building a private credit business focused on personal-injury medical receivables in partnership with Proof Capital. Keith is also an active board member and volunteer for education and veterans’ causes, including Northmount School for Boys and SADCAN Foundation.
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- Dale Powell, Director, Investments, Citibank Private Wealth
- Christopher Foster, CEO, Foster & Associates
- Dan Riverso, CEO/CIO, Jesselton Capital Management
- Robin Tessier, Partner and Head of Product & Solutions, Canada, Sagard
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