That lending rate is based on the Federal Reserve’s secured overnight financing rate (SOFR), which is currently 5.31%, plus roughly 600 basis points, he says. But even if the Fed’s rate eventually resets back to zero, Sammons continues, there’s typically a 1% floor built into private loan contracts, “so in a low-rate environment, you’re still seeing roughly 7% total returns, before fees.”
Currently the return is roughly 12%, he says. It’s no surprise then that private credit attracted $1.5 trillion last year, and is expected to grow to $2.3 trillion by 2027, according to Morgan Stanley.
Velvet Rope Access To AI
Anastasia Amoroso, the chief investment strategist at New York-headquartered iCapital, says the wealth management community’s love affair with private credit is going to continue. “There are now investment structures that are semi-liquid and accessible to private wealth. That’s what’s driving the interest, and I suspect that more and more advisors will see and use the entire income continuum,” she says.
If the average advisor allocates 3% to 5% to alternatives, and private credit is just a sliver of that, the allocation will no doubt remain small relative to everything else in a traditional portfolio, she says. It’s just that more clients will have that investment—which may well provide a vital source of capital to nascent industries, such as artificial intelligence.
“There’s definitely some opportunities to invest in artificial intelligence in public markets,” Amoroso says. “But there’s a whole host of startups that are being scaled up in private markets. Why leave out this AI opportunity in private markets when you can look at the aggregate?”
Portfolio Protection When Needed
With the SOFR floor and the floating rate keeping private credit a strong performer in the debt category, the issue of what happens when the Fed starts cutting interest rates is a bit moot. Yes, the return will drop, but it will still be higher than that of other forms of debt, sources say. And while other forms of lending may be cheaper, the speed and privacy of private credit are highly desirable to some borrowers.
The bigger question is what would happen if the economy slips into recession or is exposed to some unforeseen shock. Janet Yellen might have called a soft landing in a January interview with CNN, but if she’s wrong, some of the small and midsize companies now attracting private credit investment could later struggle to pay their debt obligations—and perhaps even default.
But advisors can protect client portfolios if they choose well from the myriad sub-asset class offerings, Sarti says.
One option, for example, is to stick with shorter loans that are more stable.
“Our favorite sub-asset class in the private credit spaces are short-term loans. In real estate, those are typically 12-month loans,” he says. “There are more structures available for the average investor to access that space. There’s more in the way of liquidity. There are lower net-worth requirements, et cetera, and the average investor can access those at lower dollar minimums as well.”
Another area Sarti delves into is corporate lending, but with one major caveat: The lending is based not on an investment’s cash flow but on its underlying assets.
Since most private credit is extended to companies based on existing or projected cash flow, if that dries up, so does the safety of the loans. So Sarti looks to something more tangible to bolster his confidence.
“That might be inventory, critically necessary equipment, maybe a trucking fleet, maybe a piece of real estate,” he says. “If something negative happens to the underlying cash flow of the company, even if it’s out of the company’s control like a recession, we have the backing of the assets to protect our loan.”
Not only does this add resiliency to the investment, but gives an advantage to those doing deeper analysis—pros who can separate the wheat from the chaff. That’s important in an area where there’s a lot of competition. Lenders who judge a company on its cash flow only have to look at the financial returns and talk with management, he says. When investors are looking at asset-based loans, they must make company visits to examine the inventory or equipment or the trucking fleet and then assess their value.
The complexity pays off for smart investors in two ways, Sarti says.
“First and foremost, we love that protection. Again, cash flow can go away very quickly. Assets cannot,” he says. “But secondly, you don’t have a ton of lenders competing for the same loan, which will drive down the yields. Yields have remained higher because there’s less lending competition for these asset type of loans.”