Opportunities Available Through Private Credit
Private credit is essentially a loan to a private company, whereas public debt is when a public company issues bonds to the public market and those bonds are traded regularly on one of the major exchanges. The terms “private credit” and “direct lending” are often used interchangeably. However, direct lending is actually a subset of private credit, which encompasses a wide variety of strategies. Importantly, private credit should be distinguished from leveraged loans and high yield bonds, which are considered public debt.
Investors often choose private credit over public bonds for the following reasons: (1) higher yield, (2) lower volatility, (3) floating rate characteristics, and (4) lower correlation to traditional equity and fixed income markets. Private credit is often offered in a “lock-up” structure, whether it is a private fund, BDC (business development company), or interval fund, to match liquidity as private investments are not traded daily in the public market.
In a rising rate environment, a floating rate loan offers the opportunity to ride interest rates up: It becomes a great hedge to the fixed rate bonds in an investor’s portfolio. However, logically, in a falling rate environment, floating rate loans may be less attractive.
Private credit yields are generally higher than publicly traded bond yields because these are privately negotiated deals with companies that generally cannot access the public debt markets and cannot get loans from traditional banks because (1) they are not suitable borrowers (e.g., cash flow-based security offered vs. asset-based security), (2) the loans may be perceived as too risky for the bank, (3) the timetable for the loans is too short, and/or (4) regulation has limited the banks’ ability to extend capital. In addition, companies may prefer to do a private loan when they need speed and certainty of execution (they need to get the loan done and need it done quickly). Similar to private equity, the lower volatility stems predominantly from the fact that private loans are not priced as frequently, not traded by the public markets, and are often priced according to a greater degree if there is an actual impairment and to a lesser degree if there is a change in spreads in the bond market. The focus is more on the private company’s ability to pay the full sum of the loan plus interest back to the lender, rather than what investors would be willing to pay for a loan at any particular point in time.
Perhaps the biggest knock-on private credit is that the borrowers would be rated “below investment grade” (aka “junk”) if they were rated by one of the major credit rating agencies. However, some of the private credit lenders go to great lengths to limit the risk of loss by lending to firms that have high cash flow with resilient market positions or are in recession resilient sectors that can withstand changes in market cycles and that are backed by successful private equity firms with deep pockets. Many also feel that good private equity firms are their own filter of quality.
Under the broad category of private credit, there are various types of strategies each with their own set of risks. Strategies can be focused on capital preservation and consistent income such as senior debt funds or strategies can be focused more on capital appreciation such as distressed debt funds. Some types of private credit strategies include direct loans to U.S. software companies, health care companies, or food and agribusiness companies.
One type of strategy that The Colony Group is currently conducting diligence on within private credit is direct lending to food and agribusiness companies. Examples of agribusinesses would be farming equipment manufacturers and food distribution companies. Agribusiness customers have not had access to the variety of financing options that middle market borrowers in other industries have had. The borrowers are vertically integrated companies, processors, and branded food companies that have relatively stable cash flows. These types of companies have typically been able to maintain their margins in different cycles due to their ability to pass along cost increases to customers.
The agribusiness sector has a limited number of market participants providing senior debt, which has mostly been split between Farm Credit lenders and commercial banks. Farm Credit is a nationwide network of 71 institutions in the United States who support rural communities and agriculture with credit and financial services. While the Farm Credit system has performed well as a senior lender in this space, there are many borrowers in this sector that have incremental capital needs that cannot be met with senior debt alone. This provides an opportunity for private lenders in this space who can partner with Farm Credit and offer a loan packaged together called a unitranche loan or the private lender can offer their own private loans directly to the borrower.
This is just one example within the many opportunities that are available in private credit. The bottom line is that private credit investments may make sense for investors seeking high cash flowing, relatively stable investments and who are comfortable with the less liquid nature of the asset class and the risks of loaning to below investment grade borrowers.