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Benign economic and credit conditions helped many private credit managers to avoid losses over the past decade, leading to a narrow return dispersion. But higher rates, wider credit spreads and slowing revenue growth are likely to put downward pressure on many managers’ portfolios, widening the range of returns.
It’s therefore imperative for investors to assess the risk in a credit manager’s portfolio to determine whether it is well positioned to generate repeatable alpha, or has a higher potential exposure to losses.
Investors should ask five key questions. First, can a credit manager’s portfolio companies afford their debt. Second, are loan-to-value ratios acceptable. Third, are there lender protections and, if so, how strong are they. And after closely reading the terms they should conclude their diligence by examining deployment pace to see if a manager is writing too many loans, too quickly, suggesting a lack of selectivity.
Since loss avoidance has a material impact on alpha, the prudent credit manager will avoid extending loans to unhealthy companies to reduce the risk of default or a loss of principal. This is especially important if the manager deploys leverage at a portfolio level – a double-edged sword that can boost returns, but also magnify yield erosion should default rates rise due to weakness in the underlying credits in a portfolio.
In our view, private credit has the potential to produce attractive returns per unit of risk in the current climate. But conducting diligence on a manager’s portfolio is essential to expose potential risks.
