As their sophistication grows, family offices and UHNW investors are taking a page out of institutional investors’ strategies around private credit.
“Institutional investors have long seen the benefits of investing in private credit as a core component of their portfolios. And now we’re starting to see an increase in demand from family office and high net-worth-investors in Canada,” says Danielle Bentley, vice-president on the private credit team at Northleaf Capital Partners in Toronto.
The International Monetary Fund estimated the global credit market was worth more than US$2.1 trillion earlier this year.
Bentley notes that family office and high-net-worth investors have become increasingly sophisticated.
“We’re seeing them take a longer-term view to managing their wealth. And because of that private credit is becoming more attractive for their portfolios. It’s a longer-term investment with less liquidity, but they’re benefitting from a return premium to public fixed income investments with lower volatility,” she explains.
Private credit is also becoming increasingly more accessible to investor groups in Canada with the launch of new private-market fund structures that have lower investment minimums, as well as enhanced liquidity terms for the investor. That is being driven by the launch of open-end, or evergreen funds as an alternative to traditional closed-end fund structures, says Bentley.
“These structures can be very attractive to family office and high-net-worth investors because they get immediate exposure to a well-diversified portfolio of private credit investments.
Investors shifting more dollars towards private credit
Arthur Diochon, director of alternatives research (Canada) in the BMO Family Office, who is based out of Boston and works with both Canadian and U.S. clients, says that he has witnessed “a lot of excitement around private credit.”
Diochon says private credit is being raised from multiple sources, and that in his experience the most demand is coming from direct lending, a subset of private credit – providing loans to private businesses that need financing for short-term needs such as cash-flow management.
As well, “sometimes they need debt for longer-term growth plans, and for whatever reason, they don’t want, or can’t, in some cases, get debt through more traditional avenues like banks,” he says.
The broad investment community has shifted more dollars towards private credit in recent years, adds Diochon, who cites several reasons, including higher returns in many cases, banking challenges that have impacted the availability of credit to businesses, with some banks lending less than they did historically, and rising interest rates.
“We’re seeing private credit step in to fill that gap a little bit. The expectation that we’ve seen from our peers is that this reliance on private credit may persist at least in the medium term,” he explains.
Advantages of private credit
On the plus side, private markets are likely to provide a higher yield, or premium, as compensation for perceived illiquidity compared to, for example, more liquid debt such as corporate or government bonds, which can generally be traded, says James Burron, founding partner of the Canadian Association of Alternative Strategies & Assets (CAASA) in Toronto.
Besides the return premium, other benefits of private credit include a consistent cash yield which can be used to meet any short-term income requirements the family office or high-net-worth investor might have. It also offers strong capital preservation with low loss rates in comparison to public fixed income, says Northleaf’s Bentley.
Another advantage is that private credit managers tend to be focused on non-cyclical industries with stable cash flows, which drives resiliency even through market cycles, says Bentley.
Private credit is also a source of flexible long-term capital. A private credit manager can support a borrower’s long-sighted growth trajectory.
“Generally, we will start lending to a business when it’s a bit smaller. It will continue to grow through our investment and we have the ability to support the business with additional capital throughout that whole period,” explains Bentley.
Whereas banks tend to employ a one-size-fits-all underwriting approach, private credit lenders can look at each borrower and underwrite the deal based on its unique circumstances, she adds.
Confidentiality is another advantage for borrowers in terms of being able to avoid putting all of their proprietary information in the public market.
Another key advantage with private credit is that an entrepreneur can use it to inject capital into their business for continued growth without having to dilute ownership, says Diochon. Especially when markets are challenged, and the expected business valuation goes down, an entrepreneur would otherwise have to dilute more of their business to raise the same dollar amount outside of private credit.
Another positive is that with the current yield on private credit at elevated levels not experienced in over a decade, investors are being provided with strong absolute and relative returns, says Bentley.
“We’re seeing senior secured loans, which are the safest part of the company’s capital structure, first in terms of repayment priority, generating low double-digit gross returns, which is up from high single digits two years ago when base rates were close to zero,” explains Bentley.
Disadvantages of private credit
While an uptick in yield can be advantageous as a hedge in a rising rate environment, there is also a potential disadvantage if rates go up a lot, says Burron. Private credit rates are often linked to prime, which could leave borrowers at greater risk for default if they don’t have enough cash flow to cover the interest gains, he explains.
Furthermore, a private lender might not use the stringent tests that banks use before lending.
“That’s part of the way of private lending, hat they’re able to have their own rules versus what the banks can do, but rising rates can make it tougher,” says Burron.
“This can make access to funds easier – a plus for borrowers and also lenders who want to deploy funds – but extreme scenarios might lead to default, which would be disadvantageous for both,” he elaborates.
Tax is the main disadvantage associated with private credit, says Diochon. For example, if the lender is collecting 12 per cent and the tax rate is 50 per cent, that means only 6 per cent is kept, whereas there are institutions like CPP, CDPQ and other endowments that are tax-exempt and keep that full 12 per cent, and so this creates a potential handicap for an investor, he explains.
Another disadvantage for borrowers is the higher cost of capital. Also, given that private credit loans are typically floating rate, should interest rates rise, if the borrowers haven’t hedged that increase, they will need to pay more, says Bentley.
However, with borrowers, as rates come down, their ability to pay increases. “What we like about rates coming down for our clients, assuming it continues to, is that we think it makes their return profile a lot more durable. So you’ve created a more durable asset class,” says Diochon.
This has also created something of a “sweet spot” for private credit lenders, he adds, because, although their compensation isn’t quite as high as rates drop, the risk of default is much lower and their protection is, therefore, at an above average level.
“So I think there’s a nice balance there between risk and return,” says Diochon.
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