To paraphrase from Zoolander, private credit is so hot right now. It seems it is the one asset class that everyone is talking about, and it is a favourite asset class for many high-net-worth investors. Indeed, I went to a briefing this week where one financial advice group said that 70% of their assets under management were in private credit, spread across only 6 managers. All I could think was “Wow! I hope you get that right!”. I can understand the attraction of the private credit story. Non-bank lenders are moving into lending areas no longer serviced by the banks and charging a nice margin for it. This higher return was particularly attractive when interest rates were zero. However, things have changed, and I believe it is now time to be very cautious about this asset class.

You see the problem with private credit is that these investments seem innocuous and low risk. They lull investors into a false sense of security churning out a nice regular income stream at a solid margin above low-risk instruments. However, when you are investing in any form of private credit you always have to keep in mind two factors that make credit investing unique (1) the upside of any fixed-interest investment is known but is capped and (2) when things go wrong you can lose your whole investment, which can often be many multiples of the initial expected upside. Does anyone remember the Challenger Howard Mortgage Trust c.2008? It was thought safe until it wasn’t.

Given interest rates have risen substantially, I believe that investors should urgently rethink their exposure to the private credit sector for the following reasons:

1. There are reasons why borrowers in these markets are seeking alternative funding methods. There is inherent risk in what they do or who they are.
2. The more investors allocate to this asset class, the riskier it gets. The more these funds get overrun with applications, logic tells you that lending standards have to fall. I cannot tell you how many private credit funds I have seen that have all told me the same story. They are the ones with the best credit vetting process, the ones that look at 100s of deals each month and only take three. It is impossible that every player in the private credit market is only taking the best deals. Someone is lying. Unfortunately, we won’t find out who it is until things go south.
3. Private credit by its very nature is illiquid. Illiquidity is fine when conditions are ideal, it really hurts when everyone runs for the door.
4. I worry about the number of ETFs being launched in this sector. It proves how hot the asset class is and I always dislike it when funds try to give liquidity to investments that are illiquid in their nature. I always believe that the last place you want to invest is when everyone else is in it or talking about it. It feels to me, right now that private credit is a “crowded trade”.
5. Term deposit rates have improved substantially. You have to question whether private credit is giving you enough of a premium to justify the risk?
6. There are signs that insolvencies are increasing at what point does this result in defaults?

There are great private credit managers out there who are fantastic at assessing risk, but it is a crowded marketplace and there will be managers out there who have let their lending standards slip in order to gather funds under management. Conditions for private credit funds have been optimal: low rates, low defaults and high funds flows but conditions are now changing. We will only know who’s swimming naked when the tide goes out. Is the risk worth running right now for a limited upside? I don’t think so.

Kind regards,

Shelley Marsh
Outsourced Chief Investment Officer (OCIO) & Founder
Wealth Differently

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