Playing it smart with private credit

Private credit income, for example, “can be really consistent,” he said. The client gets stability during market downturns and stays invested, “and thereby we’re compounding returns quicker rather than recovering from declines.”

Uncorrelated assets “certainly provided stability to portfolios through the last market cycle,” said Loren Francis, vice-president and principal of Highview Financial Group in Oakville, Ont. “If you go back to 2022, having alternatives or private investments that yielded 8% … really helped smooth portfolio volatility.” That’s the year when both equities and bonds fell in tandem.

While yields in private credit are less than they were a year ago when base interest rates were higher and spreads were wider, “you’re still getting all-in yields of about 10%,” said Sean O’Hara, chief investment officer and lead portfolio manager with Obsiido Alternative Investments Inc. in Toronto. And considering that private credit investors are senior in the capital structure, returns come with less downside risk, he said.

Overall, “private credit is a legitimate and attractive asset class — if you play it well and play it smartly,” O’Hara said. But “it’s not attractive if you lose half your capital.”

This is a test

The asset class’s reputation took a hit with the Bridging Finance Inc. fraud case, in which thousands of retail investors lost money.

Private credit can mitigate risk via enhanced portfolio diversification. The emerging global trade war could test that value proposition.

Large exposure to sectors affected by tariffs, such as energy, is a concern, especially if the companies receiving loans from private lenders are highly levered, O’Hara said.

“We’re coming into a slowing economy, potentially,” Machel said. Investors in private credit “have to know that the fund managers have structured the loans so that they remain in control of any companies that end up struggling and, further, that new loans underwritten are ironclad.” Loan covenants, for example, help protect the lender’s investment by requiring borrowers to meet certain conditions, such as minimum earnings.

Francis said underwriting standards should be assessed to ascertain if they’ve lapsed over the past decade. Private credit has grown significantly during that time and hasn’t faced a prolonged downturn. “We’ve not really been tested” since the global financial crisis, she said.

Given economic challenges for businesses, O’Hara said he’s asking private credit managers two questions: How many loans in the portfolio are non-accrual (an interest payment has been missed), and how many loans are structured as payment-in-kind (PIK) notes (the borrower is deferring interest until the loan term ends, so the loan isn’t generating cash flow).

If a large proportion of a portfolio’s value is in PIK, “run for the hills,” O’Hara said.

Planning for illiquidity

Before deciding on a client’s asset allocation, including where private investments may fit, an advisor must understand a client’s risk, needs and target portfolio returns to meet planning objectives, Francis said.

When it comes to private credit, “most investors can have a small appetite for illiquid investments, but it’s dependent on their age and stage in life [and] need for liquidity,” she said.

Clients must understand illiquidity risk, she said. A private credit fund may provide regular distributions and windows of redemption, but “if we go into a significant downturn, there is a greater risk you’re going to be gated, redemptions halted,” she said. “You have to understand that.”

Francis asks clients how they’ll feel if, say, their 2% allocation to a private credit investment is inaccessible for a prolonged period or drops in value. (The investment would be for the long term, she said, and the client’s portfolio would be built to withstand the stress.)

Overall, her clients’ portfolios might have between 10% and 30% allocated to private investments, such as private credit, private equity and real estate.

Machel said a couple of clients called him last spring asking if they were invested in Ninepoint Partners LP’s private debt funds that announced halted distributions last year, garnering media attention. They weren’t.

Clients “get super nervous when something changes,” he said, but when distributions and redemptions are halted, that doesn’t mean investors are going to lose money. “There’s a reason why managers gate the funds and lock up redemptions, and that’s to protect all the investors.”

A private credit investment is typically inside the client’s RRSP for tax efficiency, he added, so is considered a long-term investment.

Diversification is another consideration. “The more diversity across number and size of loans, and across sectors and industries, the less chance of capital impairment,” Machel said.

Due diligence

When clients invest in an illiquid asset, they should get a premium to public markets, Francis said, and as the spread between private and public markets narrows, “you really want to understand the risks.”

Benjamin Felix, chief investment officer and portfolio manager with PWL Capital Inc. in Ottawa, is concerned that retail investors may be pitched pricey private credit investments as high return and safe when they’re not. Even for a skilled advisor, “the due diligence … is not straightforward,” given the asset class is relatively opaque, Felix said.

A lack of volatility is one of the things that makes the asset class attractive. But you can’t measure private credit risk the way you would a publicly listed asset.

“It’s hard to assess risk … because there’s no mark-to-market pricing,” Felix said. He warned against plugging a private credit investment’s standard deviation and mean into a portfolio optimizer. “That’s not right,” he said. “You can’t use standard deviation to assess the risk of private credit.”

In a video, Felix explained that valuation is also a challenge in the absence of proper benchmarking, noting that different funds may assign different values to the same loans.

And while clients may invest in private credit as part of their fixed-income allocation, Felix explained that credit managers sometimes loan to high-risk borrowers. As a result, those loans can have equities features such as warrants.

Overall, “smooth returns and generous valuations on private loans can make private credit look much more attractive than it actually is,” Felix said, citing associated research.

That research includes data that show private credit funds have large and significant excess returns gross of fees. Private credit fund managers are skilled “in identifying, negotiating and monitoring private loans to firms that could not otherwise raise financing,” Felix says. Those skills are “impressive.”

Felix’s message to private credit investors is to consider whether they’re paying higher fees and taking on more risk while getting returns that could be achieved more cheaply and with greater liquidity using publicly listed assets.

Regarding asset allocation, alternatives research provider Cliffwater says what’s key is that private assets be penalized for their illiquidity, either directly through portfolio constraints or indirectly by placing an illiquidity tax on their expected returns.

As far as the pricing of private assets, Cliffwater’s research finds that “anchoring” — leaning on past values to formulate current value — is a “material” concern with real estate valuations but not private debt valuations.

While skilled due diligence helps mitigate risk, “things happen,” Francis said, citing Covid and now tariffs. Advisors should discuss with clients how a downturn will affect their portfolios, she said.

Francis described a due-diligence process that includes myriad factors, including understanding the technology that underlies underwriting decisions and ongoing portfolio monitoring. “You have to go deep [into due diligence] to say, ‘This is something that makes sense,’” she said.

Machel said that “building portfolios that are not just stocks and bonds requires an enormous amount of work,” and not only on the front end. “You don’t just buy it and you’re done; it requires due diligence along the way.”

O’Hara said he puts in 15 to 20 hours of upfront work on a given private credit strategy. If you don’t have that time and decide to forgo private credit, that’s “a good decision,” he said.

Sizing up the manager

O’Hara said private credit investors can lower their risk via manager selection. Unlike in Canada, the U.S. lending market is dominated by non-banks, and he allocates mostly to large U.S. managers that provide loans to mid-market non-cyclical businesses owned by private equity sponsors.

“That is what makes the most sense for an asset class where you’re looking to avoid unnecessary levels of risk,” O’Hara said. “When a sophisticated private equity firm owns a business, they are not going to have that business go belly up, because their capital is at risk first, and they’re going to do what it takes to ensure the business is a success.”

And with a loan-to-value ratio of, say, 40%, “the first 60% of the capital structure is equity, which is owned by the sponsoring private equity firm, so that gets wiped out first before the lender gets impaired,” he said.

Further, large managers manage institutional capital, with governance to match. “If you’re giving money to a firm that is only managing retail capital, you know their governance practices are likely not what they would be at a KKR [&Co. Inc.], for example,” he said.

Full-service brokerages in Canada are “preferring to approve some of those larger and more established” managers such as Blackstone Inc., KKR, Brookfield Asset Management and Carlyle Group Inc., said Vince Linsley, associate director, Canadian research team, with ISS Market Intelligence, in an email. Such firms have “more resources that can aid in the administration, distribution and education, and access to alternatives.”

Other considerations when selecting a manager include type of credit and diversification. The biggest managers will be dealing in multibillion-dollar financings for infrastructure projects, for example, whereas smaller managers will be investing in small- to mid-market companies, Francis said.

Regardless of size, she wants to know if a manager invests in its own funds, at what percentage and if it borrows to do so. “We prefer not to have any leverage,” she said.

Francis also described the importance of manager skill and underwriting capabilities, as demonstrated through cycles. Investors should also know what kind of analysis and updates they’ll receive, she said.

And when issues arise, “you want your managers to be able to roll up their sleeves and get involved with the underlying companies.”