Could Canada's private credit space be heading into a watershed year?

After the rapid increase in interest rates alongside a pullback in activity by traditional lenders in 2023, Canada’s private credit space could be heading into a watershed year.

That’s according to alternative investment firm Ninepoint Partners, which laid out its views on the space in its recently published 2024 Market Outlook.

While the year ahead will certainly test the sector’s ability to adapt and offer innovative approaches, the firm says lenders that can navigate those trends could reap significant rewards.

“There have been two key drivers for private credit in 2023 and going into 2024,” David Sum, Managing Director, Alternative Income Group at Ninepoint Partners, told Wealth Professional.

The first factor, Sum notes, relates to the availability of credit from traditional lending sources. With steep declines observed across broadly syndicated market issuances including new market issuances, he says there’s been an increase in lending opportunities for private credit firms.

In its outlook report, Ninepoint highlighted how increased regulatory scrutiny and heightened capital requirements have caused banks to pull back from their lending.

The brisk rate hikes since 2022, he adds, have created an environment of significantly higher interest rates than what we’ve seen in recent years. He says that has supercharged yields for older vintage loans in portfolios, as well as new loans coming into the pipeline.

“I think the combination of those two has really created an interesting dynamic looking ahead over the next year for the private credit space,” he says.

From Ninepoint’s perspective, Sum says direct senior secured loans represent one particularly interesting corner of the private credit space. Because direct loans involve a bilateral agreement between borrower and lender, he says there’s a lot of transparency that goes into those transactions.

These transactions are well-collateralized, Sum says, adding that they sit at the top of the capital structure. Also noteworthy is the fact that the underwriting for such loans involves a substantial amount of detailed due diligence. Over the past few years, he says there's been a lot of lender-friendly documentation, further enhancing the appeal of the asset class.

“We believe this combination will provide a good cushion in terms of credit risk for direct senior secured loans,” Sum says. “In the current high-interest rate environment, transacting these loans with strong covenant structures can generate strong risk-adjusted yield returns for investors in 2024.”

Given the tailwinds for the sector, Sum argues that private credit is a viable area for investors to allocate part of their portfolios to as a source of diversification and income. Exposure to that alternative investment class, he adds, can help mute some of the potential volatility in public market asset classes.

Looking ahead, he says financing conditions are likely to remain generally restrictive, providing opportunities for private credit firms to step in to continue supporting and providing capital for borrowers.

In markets like these, Sum says it’s crucial for investors to work with an experienced private credit manager. A manager who understands different market cycles and has the resources for thorough underwriting and credit risk analysis is key, he says, particularly when it comes to structuring loans with appropriate protections and risk mitigations.

As many Canadian companies are confronted with increased debt servicing and refinancing costs over the coming year, putting pressure on cash flows, Ninepoint says the role of private credit lenders has expanded from just being providers of growth capital to being significant sources of rescue financing.

Managers that have experience dealing with special and distressed situations and complex credit structures, the firm argues, will have numerous opportunities to help small- and medium-sized businesses across Canada with flexible and bespoke solutions.

“From a portfolio perspective, it really is about working within the portfolio to understand where alternative investments – private credit being a subset of that – fits best in terms of both sizing and understanding liquidity needs,” Sum stresses.