How higher interest rates have sparked ‘magic’ in private credit

While major central banks’ aggressive rate-hiking campaign over the past year and a half has posed a challenge for public markets, it’s also created compelling opportunities in the North American private credit space.

That’s according to two esteemed experts at the second annual Ninepoint Alt Thinking Global Investment Forum, which was held at the Fairmont York Hotel last week.

During a pre-event media briefing moderated by John Wilson, co-CEO of Ninepoint Partners, leaders from two of Ninepoint’s sub-advisors shared insights on trends in the private credit markets, as well as the conversations they’re having with advisors and investors seeking exposure to the space.

A ‘magic moment’ for private credit

“It's a bit of a magic moment in the private credit markets,” said Arif Bhalwani, CEO and Managing Director of Third Eye Capital, one of Canada’s largest private lenders and a sub-advisor to Ninepoint Partners. “That stems from the inverse relationship that you always have between interest rates and leverage.”

Bhalwani noted that in the cash flow-based lending context, higher interest rates typically mean lower returns on EBITDA and a higher equity cushion. For asset-based lending, it means lower advance rates and higher returns.

While banks control 80% of an estimated $320 billion in annual disbursements across Canada, Bhalwani said Canadian private lenders today are able to underwrite loans based on conservative structures and get high rates relative to the banks, where prime rates are in the neighbourhood of 7.25%.

“Discussions are much easier to have with companies that are really willing to pay up for speed of execution, certainty of capital, and having that loan structure customized to what the borrower needs,” he said.

Mick Solimene, managing director and portfolio manager at Monroe Capital, a US-based specialist asset manager in private credit, painted a similarly constructive picture from the American perspective.

Solimene said private credit in the US has grown due to a secular shift in how lending is done in the country over the past few decades. That’s been driven by several developments including the Dodd-Frank Act, consolidation in the US banking system – which led to banks focusing more on larger companies at the expense of small ones – and the evolution of the private equity space within the US.

“Today, you've got over 12,000, private equity owned businesses; 20 years ago, you had less than a couple of thousand,” Solimene said. “The whole ecosystem of the United States has changed from a private equity orientation, and an orientation where the banks are less than or less involved in providing financing for privately held companies.”

Amid rising interest, education remains key

While a great deal of lending in Canada is concentrated among the Big Six banks, Bhalwani said that concentration has also resulted in higher regulatory constraints, with Canada’s banks having the highest Tier One capital ratios across the G20 group of countries. That opens a gap for private credit lenders to come in, though they also face the challenge of educating borrowers on their potential advantage as a source of financing when banks aren’t an option.

“Why take a chunk of your company and give it away? Private credit can provide you with that transitional financing until you can ultimately graduate,” he said. “Part of that education is that private credit is not predatory; they’re not there to invest and then liquidate. They’re not there as a lender of last resort.”

As economic and market challenges over the past few years have ignited more conversations about alternative investments, the community of advisors interested in learning about private credit products has grown dramatically. In a poll of more than 100 advisors at the forum last week, around two thirds (63%) said they expect to raise private credit exposures in their client or model portfolios over the next 12 months, while 83% expect to increase their alternative asset exposure over that time.

While there’s no questioning the increased interest surrounding private credit today, Wilson said Ninepoint is maintaining its education-first approach to engaging with advisors.

“We’ve always led the same way, which is with education,” he said. “We have an alt thinking library, we do webinars, and we do white papers … because investors in Canada have historically not had a large allocation to these types of strategies. So there’s a lot of learning that has to go on before they can feel comfortable.”

Around a decade ago, advisors would typically object to private credit because of its illiquidity. But in the course of their conversations, they would come to realize that their clients – especially for those in the high-net-worth segments – are happy to trade off some liquidity to get private-market exposure, which offers non-correlated returns and a smoother investing journey.

“Our role is to help them understand what those trade-offs are, and understand how the strategies work,” he said. “It’s more work than if you just run an equity fund, but that doesn’t mean it’s not worth doing for the advisors … The banks, the wealth channels, they all know they need more of these sorts of things. They understand why everyone else is doing it.”