Market Matters

The Role of Private Credit in the Post-Pandemic World

14 October 2024

8 Minute Read

Inigo Fraser Jenkins Investment Strategist

Robertas Stancikas Senior Research Associate

The forces that have ushered in higher private-market allocations in recent decades are still in place—if anything, they’ve strengthened. Allocations will likely continue to grow as investors seek higher inflation-protected returns and diversification.

New Investment Regime

Investors can’t determine the role private assets play in asset allocation in isolation—the macro backdrop is a key driver. In our view, the post-pandemic world presents a new macro equilibrium that demands a response.

The key features of this new regime are:

Inflation that will settle higher than its pre-pandemic average, raising the bar for investors seeking to maintain purchasing power

A lower-growth outlook than the norms of recent decades, and more pressure on corporate profitability from deglobalization, a declining working-age population and a shift of bargaining power in favor of workers

Bonds that are less likely to be an effective diversifier in portfolios—with the 2022 experience a wake-up call to investors.

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In our view, this new regime is likely to translate into stronger demand for private assets—credit, in particular.

Bank Pullback Creates Opportunity for Alternative Lenders

Along with investor demand for private assets there is a supply case to hold them too. The multiyear pullback of traditional credit providers (namely banks) has intensified. Banks are very unlikely to increase their share of credit that is extended to corporations and other entities, given the regulatory backdrop.

We will likely see a further structural shift toward nontraditional lenders, so we expect a multi-year tailwind for private credit.

In the US, the share of credit provided by non banks overtook credit extended by banks in the mid-1980s ; since then, all net credit growth (as a share of gross domestic product) has come from non banks.

Alternative lenders are well-positioned to capitalize on these dynamics: their investor base has a longer time horizon, and alternative lenders can offer more customized, flexible solutions for borrowers as well as stronger protection from covenants—loan-terms or conditions.

We do recognize that there are cyclical concerns in terms of slower growth implying greater default risk and an inflow of capital implying a smaller illiquidity premium. Nevertheless we see the case for private credit as robust given longer term investor needs.

US Credit Growth Has Come from Non-Bank Sources

Historical analysis and current estimates do not guarantee future results.

As of March 31, 2024 | Source: BIS and AB

Floating-Rate Structure Is an Inflation Hedge

Unlike public credit, most segments of private credit are floating rate.

This means that expected returns can decline with interest rates, but crucially, over the longer term, this offers a hedge against higher future unexpected inflation—a hedge we think is highly attractive in the current macro environment. Yields on private loans are attractive by historical standards. According to Cliffwater, LLC, direct loans currently yield 12%.

As Of September 26, 2024

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Yields on private loans are attractive by historical standards.

Diversifying Public-Market Return Streams

In our view, bonds are unlikely to diversify equities as effectively as they have in recent decades, and private assets offer a degree of diversification. But it’s important to define diversification appropriately.

Diversification is going to become even more critical if bonds can no longer perform that task as effectively. Private assets can help with this. However, the fact that private assets aren’t marked-to-market provides only a veneer of diversification; the real diversification of private assets comes from investors’ ability to buy return streams unavailable in public markets. Real estate and green infrastructure, for instance, are closely linked to the real economy; it would otherwise be hard or sometimes impossible to gain this exposure through public markets alone.

Private Equity or Private Debt?

Over the past two decades, most flows from investors into private markets have headed for private equity. The returns there have been impressive, but we think investors should lower their future expectations.

Historically, private-equity firms’ key advantage has been the ability to acquire companies at attractive valuation multiples, but those deals are less lucrative today. According to Preqin, the median multiple of global enterprise-value to EBITDA for buyout targets was less than six times in the late 1990s and early 2000s; by 2022, it had grown to 11.4 times.

Private equity also relies heavily on leverage, but the uniquely favorable decades-long environment of falling yields is over. Higher starting multiples and a higher cost of debt will be a drag on future performance.

Finally, the amount of dry powder (private-equity capital that’s committed but not invested) continues to break records every year, reaching nearly $2.8 trillion at the end of September 2023, according to Preqin. With so much capital looking for a limited number of investments, the competition is intensifying.

Even though private credit has also grown rapidly in recent years, it accounts for a much smaller share of institutional investors’ portfolios, suggesting ample room for allocations to grow. The existence of an illiquidity premium for investing in private equity at this juncture is in doubt. On the other hand, we think that there’s still a premium available in private debt, and it’s easier for an investor to assess that premium beforehand.

So, while we believe private equity will remain a key part of investors’ private asset allocations, we think marginal new allocations should go toward private credit.

Historical analysis and current estimates do not guarantee future results.

As Of March 30, 2024 Source: Preqin and AB

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We think marginal new allocations to private assets should go toward private credit.

Inigo Fraser Jenkins Investment Strategist

Robertas Stancikas Senior Research Associate

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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