August 24, 2023
Article
Even as interest rates have risen, the attractiveness of private credit remains because there is a persistent illiquidity premium, compared to traded debt
A combination of tighter financial conditions and higher borrowing costs is creating “a golden road of opportunity” for private lenders who are bucking fears that rising interest rates, inflation, and geopolitical uncertainty would put a chill on the red-hot private credit asset class.
Private credit has become one of the fastest growing and most attractive private asset classes in the years following the Global Financial Crisis. The private credit market is expected to grow to $2.3 trillion in assets under management globally by 2027 and become the second-largest private asset class by the end of this year, according to Preqin.1
“The biggest tailwind for private credit more recently has been its ability to deliver higher returns than traditional fixed-income investments in a low-yield environment,” said Arif Bhalwani, Chief Executive of Third Eye Capital, one of Canada’s largest private lenders.
There were concerns that rising interest rates would slow this momentum as investors looked to more liquid fixed income products offering similar yields. But that hasn’t proven the case, Bhalwani said.
“Even as interest rates have risen, the attractiveness of private credit remains because there is a persistent illiquidity premium, compared to traded debt,” he said. “It also offers potential returns similar to private equity with superior downside protection and quicker returns on investment.”
The Ninepoint-TEC Private Credit strategy has, for example, delivered net returns of 10.23% on average annually since its inception in 2010.2
“Investors and managers are increasingly recognizing the benefits of diversifying their portfolios to include private credit,” said John Wilson, Co-CEO at Ninepoint Partners. “The lack of correlation with equity and fixed income products means that private credit can contribute steady, risk-adjusted returns even in times of extreme market volatility like we saw in 2022.”
The Canadian Difference
The dramatic inflow of capital into the private credit market began in the aftermath of the Global Financial Crisis. The added regulations imposed on the U.S. banks saw them pull back on lending to higher risk borrowers, primarily small and medium sized businesses (SMEs). This created a vacuum that private credit lenders were quick to fill.
More recently, the crisis at U.S. regional banks has created even more opportunities for private lenders as those smaller banks have further stepped back from lending.
In Canada, the private credit market remains less mature than in the U.S. and Europe. The regulatory environment is more accommodating to SME loans in Canada, which is why many of the banks continue to dominate business lending in the country, Bhalwani said. There are other factors that are dragging on the proliferation of private credit lenders in Canada, including that private lending in the country is primarily focused on real estate and natural resources as opposed to the U.S. where lending spans a broader range of sectors like technology, healthcare, and consumer goods where there is generally more activity.
The Canadian market is also much smaller, and while that means there is less competition, it also means there are also fewer opportunities for large-scale investment, Bhalwani said.
“The investor landscape in Canada is also slightly different, with retail investors leading institutional investors in the adoption of private credit as an asset class. Outside of the largest public pension plans, institutional investors in Canada are still significantly underweighted in private credit relative to their U.S. peers,” he added.
"Rising interest rates are providing a boon for the top private lenders in Canada because those lenders can offer unique solutions to businesses feeling the squeeze of higher borrowing costs"
Rising Interest Rates Creating Opportunity
Still, rising interest rates are providing a boon for the top private lenders in Canada and elsewhere because those lenders can offer unique solutions to businesses feeling the squeeze of higher borrowing costs and increasingly unsustainable debt burdens, Bhalwani said.
“This means a lot of companies will not be able to service debt from cash flow, leaving them with unstable capital structures,” Bhalwani said. Private credit firms, like Third Eye Capital, have significant distressed and restructuring experience in multiple sectors and market cycles which they bring to the table.
“We are meeting with companies every day that require creative liquidity arrangements and are showing them how using our unique brand of asset-based financing can help them bridge cash flow problems and support complex debt restructurings and rescue packages,” he said.
Bhalwani said this is creating a “golden road of opportunity” for experienced private credit lenders and their investors despite the prevailing market headwinds.
Investor Interest
In its 2023 annual report on global private credit, Preqin found that investors and managers agree that the macroeconomic environment is challenging, and that inflation, interest rates and geopolitical turmoil are a concern for the sector. Nevertheless, 63% of investors surveyed by Preqin said they intend to increase their allocation to the sector over the long term.3
That has caught the eye of private credit investors. There was an estimated $438 billion in dry powder pursuing private credit deals at the end of June 2023, according to Preqin.4
“With that much capital chasing deals, it’s little wonder the private credit sector has been so active, despite the M&A and equity capital markets slowing to a crawl,” said Ramesh Kashyap, Ninepoint Managing Director and Group Head of Alternative Income. “This has also brought healthy returns to our investors and great opportunities for our partners in their loan books.”
The Ninepoint-TEC Private Credit strategy has already had two significant loan exits in 2023, which have generated internal rate of returns that are very favourable to investors.
The first was in June when Pieridae Energy Limited successfully refinanced a senior secure revolving loan facility and fully repaid its $185 million in outstanding debt to funds managed, sub-advised or operated by affiliates of Third Eye Capital. Through this repayment, the Ninepoint-TEC Private Credit Fund and Ninepoint-TEC Private Credit Fund II (the Funds) received their respective pro-rata share of collectively $123 million in the refinancing.
The second came shortly after in July when the Funds, along with Third Eye Capital, announced that they had successfully exited their debt and equity investment in Cricket Energy Holdings Inc. That exit resulted from the proceeds generated by a strategic majority sale of Cricket’s subsidiary, Provident Energy Management Inc., to funds managed by Northleaf Capital Partners.
Lion’s Share of Allocations
From a fundraising perspective, investors have increasingly become focused on the more established and experienced firms, who are attracting the lion’s share of private loans, making it harder for upstarts to compete. Traditional ‘plain vanilla’ private credit approaches are therefore increasingly transitioning into passive strategies, mirrored in their more modest, leverage-dependent returns, Bhalwani said.
He said businesses that are overlooked or find the terms of traditional bank loans too restrictive can offer fertile ground for firms like Third Eye Capital who are willing to customize solutions and bundle value-added services to their capital, such as strategic advice, operational expertise, and business connections.
The Ninepoint-TEC Private Credit strategy has already had two significant loan exits in 2023, which have generated internal rate of returns that are very favourable to investors
“Asset-based financing, special situation lending, and distressed investing stand out as more specialized facets of private credit,” he said. “These niches offer the potential for generating active alpha, largely attributable to the unique expertise and specialized skill sets of their managers, which are in short supply. Consequently, these differentiated strategies not only elevate the returns but also underscore the value of manager skill in the private credit space.”
1 Preqin Global Report 2023: Private Debt, September 30, 2023, p. 7
2 Performance cited is a composite and groups the performance of the following funds:
1) Sprott Private Credit LP (PC LP), Class F, management fee 1.80% from June 30, 2010 to December 31, 2011; PC LP merged
into SPCT effective December 31, 2011.
2) Sprott Private Credit Trust (SPCT), Class F, management fee 1.60% from January 2012 to July 2017; SPCT merged into SPCT II effective July 31, 2017 at which time SPCT II was renamed Sprott-TEC Private Credit Trust.
3) Sprott Private Credit Trust II (SPCT II), Class F, management fee 1.30% from July 2016 to July 2017; for this period, because more than one fund existed, the performance was calculated using the weighted average based on assets under management. Sprott-TEC Private Credit Trust was again renamed into Ninepoint-TEC Private Credit Fund on May 1, 2018.
4) Ninepoint-TEC Private Credit Fund (TEC), Class F1, management fee 1.45% from August, 2017 to September 2022. On September 30, 2022, unitholder approval was received to restructure TEC whereby TEC was terminated and Ninepoint-TEC Private Credit Fund II (the Fund) was launched. Since TEC’s objective changed as a result of termination, it is not included in composite performance post September 2022.
5) Ninepoint-TEC Private Credit Fund II (the Fund), Class F1, management fee 1.45%, from October 2022 to December 2022.
The funds aggregated for the performance composite all share a similar investment objective and strategy; return calculations are net of fees. Effective August 1, 2017 the investment manager of the Fund changed from Sprott Asset Management LP to Ninepoint Partners LP. Historical returns are not indicative of future performance.
3 Preqin, op cit., p. 7
4 Preqin Quarterly Update: Private Debt Q2 2023, August 2023, p. 4