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The Roles of Private Credit in an Investment Portfolio

16 July 2019

The years following the financial crisis of 2008 have seen the rise of the private credit asset class. As a way to mitigate the ripple effects of the U.S. market crash, Canada enforced fiscal policies meant to stimulate the economy and restore its stability. On October 8, 2008, the Bank of Canada reduced its target overnight rate from 3% to 2.5%, with other leading financial institutions following suit. More rate cuts were made to encourage borrowing and liquidity, especially in the SME and startup sectors.

Cheap debt encouraged capital investments, which also widened the market for alternative lending. The establishment of more businesses led to more employment and, eventually, the strengthening of the market’s purchasing and investing power.

More private lending players were created at the beginning of the recovery phase, and as the dust settled in more recent years, the asset class kicked into gear. With the economy having been stabilized, regulatory policies have shifted to management and moderation rather than stimulation. As banks become more and more restricted and conservative with lending, private creditors are seeing the rise of their market share.

Not only did the economic movements of recent years encourage demand (more borrowers); it also created more private credit investors. It is not just demand, however, that has boosted interest in the asset class. Investors, advisors, and fund managers see private lending as great additions to a portfolio for reasons beyond a favourable economic environment. Aside from being an ideal diversification instrument, private credit also adds value to a portfolio by serving a variety of functions.

Private credit as a hedge against market volatility

Unlike public debt investments, private debt is neither financed by banks nor traded in the open market. While not completely impervious to what goes on in the economic landscape, alternative lending is more resistant to market fluctuations than its public counterpart.

Private lenders have more control over the fate of their capital because they can set their own lending terms and interest rates. As such, the private debt sector is able to respond to market changes in quicker and more targeted ways.

Its floating-rate structure is an interesting way private credit hedges against inflation.

Inflation has a direct correlation to the performance of asset classes like stocks and private equity. Increases in prices affect companies’ input costs, resulting in labour downsizing and decreased buying activity on the consumers’ side. Inflation also causes confusion among investors trying to evaluate risks because its effects on the market aren’t simultaneous; companies may take time, for example, to react and pass on additional costs to consumers. As a result, profits will drastically thin out at first before experiencing the marginal recovery brought on by price increases. Afterwards, the consumer market needs to get acclimated to the new prices and the corresponding decrease in purchasing power. Only then will profit margins stabilize again.

While these types of asset classes—stocks and private equity—suffer the consequences of inflation, private credit is naturally resistant to the phenomenon. Debt principles remain the same despite market fluctuations, and a floating rate allows private lenders to compensate when interest rates fall in response to inflation. The interest appreciation neutralizes the economic effects of increases in operational costs, capital expenditures, and other fees.

Additionally, employing the right strategy will allow an investor to benefit from the market condition, as opposed to merely offsetting its effects. Inflation and low-interest rates put consumers in a borrowing mood, and the ability to offer more flexible terms gives the private credit category a competitive advantage.

Private credit as a high-yield instrument

While less liquid than other asset classes, private credit yields greater returns. Bonds, which are popular especially among conservative investors for their low-risk reputation and fixed-income structure, have been underperforming in recent years. At an average return rate of 2% to 4.5%, bonds are barely compensating for Canada’s inflation rate, which rose to 2% in April of 2019.

On the other hand, private credit offers historically better returns, with many of the transactions secured by collateral. The higher yields and real property securities make the asset class particularly attractive.

Private credit as a form of impact investment

Investors are becoming increasingly aware of the benefits of having impact-oriented allocations in their portfolios. Private lending can provide exposure to these types of ventures when it gives social enterprises and cause-driven startups access to funding. These types of investments have measurable, concrete, real-world results that are visible beyond numbers and statistical reports.

Additionally, today’s investors and potential business partners place more value on social responsibility than previous generations. For this reason, impact investments foster goodwill and make great additions to a portfolio.

Private credit as a way to gain real estate exposure

Investors have been known to use real estate to round off their portfolios. Alternative lending investments allow them to do this for much less capital than if they were to engage in direct ownership of properties. A private debt investment is also less demanding as property maintenance, tenant management, and vulnerability to property price fluctuations are all virtually immaterial.

Furthermore, risks are more manageable because investments are secured by collateral, and the capital pool serves multiple transactions instead of wagering on the success of a single loan’s performance. A Mortgage Investment Corporation (MIC) like CMI, for example, diversifies an investor’s money across several loans.

An investment portfolio must balance risks and returns, but it should also feature value-adding ventures that welcome growth opportunities and complement other asset classes. For these reasons, many investors are wising up to the benefits of capitalizing on the private debt market. While risks do exist, a reputable institution with good underwriting practices will be in a better position to protect investors and simultaneously improve their portfolios.

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