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 Strategy insights​

The case for private credit after a reset in the public markets

April 6, 2023 | 10 min read

Over the course of the last year, global capital markets were forced to contend with geopolitical uncertainty, persistently high inflation, and weakening economies around the world. Central banks responded to inflationary pressures by raising short term interest rates, leading to higher all-in yields in the public fixed income markets – a dynamic which has some allocators asking if they should re-direct future private credit allocations to the public fixed income markets.

While the trajectory of the public markets may seem less clear for investors, particularly after recent volatility in the banking sector, we believe that the private credit market continues to offer allocators compelling advantages relative to the public markets – including an illiquidity (or yield) premium, meaningful downside protection, and greater resiliency during periods of heightened volatility; themes that we explore in greater detail below.  

Private credit market offers an illiquidity premium 

The direct lending market1 has outperformed the broadly syndicated loan market2 in 16 out of the last 17 years,3 which highlights both the consistency and reliability of the asset class. Over that time, the direct lending market has, on average, outperformed the syndicated loan market by 400 bps on a total return basis and exhibited a much shallower drawdown during periods of market stress, like the Global Financial Crisis (GFC).4 Today, the illiquidity premium for the direct lending market has compressed relative to other historical periods, but it remains positive.  

In the chart below, we plot the historical yield of the broadly syndicated loan market relative to the direct lending market for first lien securities and find that, as of year-end 2022, the direct lending market continues to outyield the syndicated loan market by 1.8%. Additionally, the current all-in yield for first dollar risk is between 11-12%, which nears an all-time high for the senior direct lending market, while still maintaining an average loan to value of approximately 40%.5   

Historical yields: broadly syndicated loans vs. direct lending

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Source: Refinitiv data as of 12/31/2022. 

James Athanasoulas

Managing Director

Bill Cole, CFA, CAIA

Principal

Private credit tends to be more resilient than public fixed income 

The direct lending market is generally focused on more resilient industries that are less susceptible to volatility due to economic cycles, such as business services, healthcare, and information technology. These sectors tend to exhibit greater cash flow stability and predictability with less sensitivity to changes in the broader US economy. As the private credit market has grown from $311.5 billion in 2010 to nearly $1.4 trillion in 2022,6 there is an even greater opportunity for private credit managers to build highly diversified portfolios by industry, issuer, and security type (first lien, unitranche, etc). 

In addition to focusing on less cyclical segments of the market, direct lenders benefit from the bespoke nature of private credit transactions, where information is shared between the private equity sponsor and the lender to ensure transparency and alignment of interests. Both parties have the flexibility to amend terms of the agreement throughout the life of the loan to ensure that the structure of the transaction supports the borrower’s ability to service its debt obligations. This flexibility is not available in the public markets where a high yield bond, for example, could be spread across hundreds of investors at any point in time — making it more difficult to establish ongoing alignment of investor interests and agreement on potential amendments throughout the life of the loan. More specifically, in a downside work-out scenario, a private credit deal can potentially better preserve enterprise value as a small group of like-minded lenders is more inclined to agree on a restructuring plan than a disparate group of bondholders that may choose to sell to distressed players and delay an orderly restructuring.  

Practically speaking, the structural features of the private markets result in lower default rates and higher recovery rates. The historical default rate of the private credit markets has been close to 2% with recovery rates near 60-70% for senior loans.7 This compares to the high yield market which has experienced default rates closer to 3.6% and recovery rates closer to 45%.8    

In addition to the lower risk and higher recovery rates, private markets continue to gain share of private equity financings. The direct lending market represented 72% of financings in 2022 relative to 28% of the syndicated market, which expands the addressable market for private credit managers and allows them to build increasingly diversified portfolios across industries and borrowers.9  

Public fixed income markets can be unstable

The public fixed income market is an over-the-counter market, meaning that bonds and syndicated loans do not trade on an exchange like equities. Instead, dealers facilitate the trading of fixed income securities by lining up buyers and sellers of individual securities, and they are compensated by capturing a bid-offer spread. Dealers use balance sheet capital to support orderly markets, often warehousing fixed income securities when there is a seller of a particular security but not a buyer at a given point in time. The willingness of a dealer to use balance sheet capital for this purpose historically provided liquidity and price stability in the fixed income markets.  

However, there have been two important developments in the public fixed income market since the GFC which have had important implications both for the fixed income market broadly and the role it plays in investors’ portfolios. First, the size of the US bond market has increased meaningfully, with the market value of the US fixed income market increasing from just under $30 trillion pre-GFC, to over $53 trillion today.10 Second, the amount of capital devoted to market making activities by dealers has remained between $30-40 billion, post GFC, despite significant growth in the fixed income markets.11  

This relationship has made the public fixed income markets inherently less liquid as there is proportionally less capital relative to the size of the market from the dealer community to provide liquidity. In turn, it has led to increased price volatility across public fixed income markets. Liquidity has also become more sporadic. For example, when the volatility in risk markets rises, liquidity tends to dissipate in fixed income markets as dealers are less willing to provide balance sheet capital to make markets for securities when the flow is one directional.

In the chart below, we plot the cost of liquidity of the corporate bond market, which is a function of the bid/offer spread and the duration of the underlying securities. This shows that during periods of heightened stock market volatility, bid/offer spreads typically widen and the cost for liquidity increases meaningfully in the public markets, often when liquidity is needed most by investors.   

Cost of liquidity for corporate bonds

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Source: Federal Reserve, “Dealer Inventory Constraints in the Corporate Bond Market during the COVID Crisis” 7/15/21. 

Chart shows the average divergence between an individual bond’s yield and the yield curve of its issuer, which is representative of the cost for liquidity for a particular issue. 

Key takeaways

Historically, investors allocate to public fixed income markets to generate income, diversify risk assets, and to preserve liquidity. Since the GFC, instability within the fixed income markets has caused many segments of fixed income to trade directionally in line with other risk assets, like equities, particularly during periods of volatility when diversification is needed most. Finally, as witnessed during the early days of the COVID pandemic, or the most recent bank crisis, liquidity in the fixed income market has tended to dry up at inopportune times, diluting one of the key benefits that public fixed income markets are meant to provide allocators in volatile markets.       

We see three key reasons why investors can continue benefitting from an allocation to private fixed income versus public:  

Investors in private credit are compensated for locking up their capital with an illiquidity premium. Even after the most recent reset in the public fixed income markets, there is still an illiquidity premium to be earned in the private credit markets.

The private credit market is focused on less cyclical sectors and tends to be more resilient than the public fixed income markets, which is evidenced by lower default rates and higher recovery rates.   

Private credit offers a point of stability and diversification relative to other risk assets and has been less impacted by technical buying/selling pressures and the broader instability of the public fixed income markets post-GFC.     

The current environment offers a particularly attractive opportunity in the private credit markets. Due to base rates rising to near 5%, the widening of credit spreads, and the closure of the syndicated loan market, the private credit market is currently pricing north of 11-12% for first dollar risk, and opportunities in the junior credit market are pricing north of 15%.12 Despite higher all-in yields, many opportunities are coming to the market with lower leverage levels than just a year prior, which is why we believe this could be a particularly attractive vintage for private credit funds. Additionally, the floating rate nature of the asset class provides a valuable hedge to rising interest rates, compared to the public markets which tend to focus on fixed rate securities that can be adversely impacted from rising rates. Pulling this all together, we believe that private credit managers, with access to best-in-class GPs, have the ability to focus on the highest quality deals and deliver risk adjusted return that is difficult to find in the current market environment.  

Would you like to discuss current opportunities in private credit?

Contact us
  1. As proxied by the Cliffwater Direct Lending Index (CDLI).
  2. As proxied by the Morningstar LSTA Levered Loan Index.
  3. Source: Cliffwater, data as of 12/31/2022.
  4. Source: HarbourVest, based on Cliffwater and Morningstar data through 12/31/2022.
  5. Source: HarbourVest, as of March 2023.
  6. Source: Preqin, Global Reports 2023: Private Debt, 12/14/2022.
  7. Source: Cliffwater, data as of 6/30/2022.
  8. Source: Fitch, data as of 12/31/2022.
  9. Source: Refinitiv, data as of 12/31/2022.
  10. Source: SIMFA, as of 12/31/22.
  11. Source: Federal Reserve, as of July 2021 and NY Fed CMDI as of 12/31/2022.
  12. Source: HarbourVest Partners, data as of 12/31/22.

This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

More HarbourVest Insights

Historical yields: broadly syndicated loans vs. direct lending

Source: Refinitiv data as of 12/31/2022. 

Cost of liquidity for corporate bonds

Source: Federal Reserve, “Dealer Inventory Constraints in the Corporate Bond Market during the COVID Crisis” 7/15/21. 

Chart shows the average divergence between an individual bond’s yield and the yield curve of its issuer, which is representative of the cost for liquidity for a particular issue. 

Professional Investor Definition

“Professional Investor” under the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the “SFO”) and its subsidiary legislation) means:

(a) any recognised exchange company, recognised clearing house, recognised exchange controller or recognised investor compensation company, or any person authorised to provide automated trading services under section 95(2) of the SFO;

(b) any intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong;

(c) any authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(d) any insurer authorized under the Insurance Ordinance (Cap. 41 of the Laws of Hong Kong), or any other person carrying on insurance business and regulated under the law of any place outside Hong Kong;

(e) any scheme which-

(i) is a collective investment scheme authorised under section 104 of the SFO; or

(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated;

(f) any registered scheme as defined in section 2(1) of the Mandatory Provident Fund Schemes Ordinance (Cap. 485 of the Laws of Hong Kong), or its constituent fund as defined in section 2 of the Mandatory Provident Fund Schemes (General) Regulation (Cap. 485A of the Laws of Hong Kong), or any person who, in relation to any such registered scheme, is an approved trustee or service provider as defined in section 2(1) of that Ordinance or who is an investment manager of any such registered scheme or constituent fund;

(g) any scheme which-

(i) is a registered scheme as defined in section 2(1) of the Occupational Retirement Schemes Ordinance (Cap. 426 of the Laws of Hong Kong); or

(ii) is an offshore scheme as defined in section 2(1) of that Ordinance and, if it is regulated under the law of the place in which it is domiciled, is permitted to be operated under the law of such place,

or any person who, in relation to any such scheme, is an administrator as defined in section 2(1) of that Ordinance;

(h) any government (other than a municipal government authority), any institution which performs the functions of a central bank, or any multilateral agency;

(i) except for the purposes of Schedule 5 to the SFO, any corporation which is-

(i) a wholly owned subsidiary of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(ii) a holding company which holds all the issued share capital of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong; or

(iii) any other wholly owned subsidiary of a holding company referred to in subparagraph (ii); or

(j) any person of a class which is prescribed by rules made under section 397 of the SFO for the purposes of this paragraph as within the meaning of this definition for the purposes of the provisions of the SFO, or to the extent that it is prescribed by rules so made as within the meaning of this definition for the purposes of any provision of the SFO.

The first of such classes of additional “professional investor”, under the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong), are:

(k) any trust corporation (registered under Part VIII of the Trustee Ordinance (Cap. 29 of the Laws of Hong Kong) or the equivalent overseas) having been entrusted under the trust or trusts of which it acts as a trustee with total assets of not less than HK$40 million or its equivalent in any foreign currency at the relevant date (see below) or-

(i) as stated in the most recent audited financial statement prepared-

(A) in respect of the trust corporation; and

(B) within 16 months before the relevant date;

(ii) as ascertained by referring to one or more audited financial statements, each being the most recent audited financial statement, prepared-

(A) in respect of the trust or any of the trust; and

(B) within 16 months before the relevant date; or

(iii) as ascertained by referring to one or more custodian (see below) statements issued to the trust corporation-

(A) in respect of the trust or any of the trusts; and

(B) within 12 months before the relevant date;

(l) any individual, either alone or with any of his associates (the spouse or any child) on a joint account, having a portfolio (see below) of not less than HK$8 million or its equivalent in any foreign currency at the relevant date or-

(i) as stated in a certificate issued by an auditor or a certified public accountant of the individual within 12 months before the relevant date; or

(ii)  as ascertained by referring to one or more custodian statements issued to the individual (either alone or with the associate) within 12 months before the relevant date;

(m) any corporation or partnership having-

(i) a portfolio of not less than HK$8 million or its equivalent in any foreign currency; or

(ii) total assets of not less than HK$40 million or its equivalent in any foreign currency, at the relevant date, or as ascertained by referring to-

(iii) the most recent audited financial statement prepared-

(A) in respect of the corporation or partnership (as the case may be); and

(B) within 16 months before the relevant date; or

(iv) one or more custodian statements issued to the corporation or partnership (as the case may be) within 12 months before the relevant date; and

(n) any corporation the sole business of which is to hold investments and which at the relevant date is wholly owned by any one or more of the following persons-

(i) a trust corporation that falls within the description in paragraph (k);

(ii) an individual who, either alone or with any of his or her associates on a joint account, falls within the description in paragraph (k);

(iii) a corporation that falls within the description in paragraph (m);

(iv) a partnership that falls within the description in paragraph (m).

For the purposes of paragraphs (k) to (n) above:

  • “relevant date” means the date on which the advertisement, invitation or document (made in respect of securities or structured products or interests in any collective investment scheme, which is intended to be disposed of only to professional investors), is issued, or possessed for the purposes of issue;
  • “custodian” means (i) a corporation whose principal business is to act as a securities custodian, or (ii) an authorised financial institution under the Banking Ordinance (Cap. 155 of the Laws of Hong Kong); an overseas bank; a corporation licensed under the SFO; or an overseas financial intermediary, whose business includes acting as a custodian; and
  • “portfolio” means a portfolio comprising any of the following (i) securities; (ii) certificates of deposit issued by an authorised financial institution under the Banking Ordinance (Cap, 155 of the Laws of Hong Kong) or an overseas bank; and (iii) except for trust corporations, cash held by a custodian.

Institutional Investor / Accredited Investor Definition

An institutional investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(a) the Singapore Government;

(b) a statutory board as may be prescribed by regulations made under section 341 of the SFA, as prescribed in the Second Schedule of the Securities and Futures (Classes of Investors) Regulations 2018;

(c) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is —

(i) to manage its own funds;

(ii) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or

(iii) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country;

(d) any entity —

(i) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and

(ii) whose funds are managed by an entity mentioned in sub‑paragraph (c);

(e) a bank that is licensed under the Banking Act 1970;

(f) a merchant bank that is licensed under the Banking Act 1970;

(g) a finance company that is licensed under the Finance Companies Act 1967;

(h) a company or co‑operative society that is licensed under the Insurance Act 1966 to carry on insurance business in Singapore;

(i) a company licensed under the Trust Companies Act 2005;

(j) a holder of a capital markets services licence;

(k) an approved exchange;

(l) a recognised market operator;

(m) an approved clearing house;

(n) a recognised clearing house;

(o) a licensed trade repository;

(p) a licensed foreign trade repository;

(q) an approved holding company;

(r) a Depository as defined in section 81SF of the SFA;

(s) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere;

(t) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors;

(u) a designated market‑maker as defined in paragraph 1 of the Second Schedule to the Securities and Futures (Licensing and Conduct of Business) Regulations;

(v) a headquarters company or Finance and Treasury Centre which carries on a class of business involving fund management, where such business has been approved as a qualifying service in relation to that headquarters company or Finance and Treasury Centre under section 43D(2)(a) or 43E(2)(a) of the Income Tax Act 1947;

(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;

(x) a Service Company (as defined in regulation 2 of the Insurance (Lloyd’s Asia Scheme) Regulations) which carries on business as an agent of a member of Lloyd’s;

(y) a corporation the entire share capital of which is owned by an institutional investor or by persons all of whom are institutional investors;

(z) a partnership (other than a limited liability partnership within the meaning of the Limited Liability Partnerships Act 2005) in which each partner is an institutional investor.

An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(i)  an individual —

(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(B) whose financial assets (net of any related liabilities) exceed in value $1 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount, where “financial asset” means —

(BA) a deposit as defined in section 4B of the Banking Act 1970;

(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or

(BC) any other asset as may be prescribed by regulations made under section 341; or

(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(ii)  a corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by —

(A) the most recent audited balance sheet of the corporation; or

(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;

(iii) A trustee of a trust which all the beneficiaries are accredited investors; or

(iv) A trustee of a trust which the subject matter exceeds S$10 million; or

(v) An entity (other than a corporation) with net assets exceeding S$10 million (or its equivalent in a foreign currency) in value. “Entity” includes an unincorporated association, a partnership and the government of any state, but does not include a trust; or

(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or

(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.

Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).