Introduction to private credit and public-private solutions

1.1 Introduction to private markets and private credit

Introduction to private markets and private credit

 

This video explores the growing world of private market assets (also known as "alternatives"). In particular, you'll learn about the market for private credit and its opportunities for investors.

 

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Bryan Favilla

Director of fixed income markets at Capital Group

6MINVIDEO

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A closer look at alternative investments

 

Alternative investments, defined

Alternative investments are financial assets that don't belong to the traditional categories of public equity, public fixed income or cash equivalents, among others. They are commonly referred to as “alternatives” or “alts.” (For simplicity, we’ll use those shorter variations, too.)

 

Four main categories of alternatives

Alts cover a wide range of investments with unique characteristics. Definitions of alternative investments vary, but they can generally be grouped into these four broad categories: 

Potential benefits

Alts may help your clients pursue their long-term goals and objectives and can be an attractive complement to traditional stocks and bonds. Alts represent a broad range of investments that may fulfill multiple roles in a portfolio, including:

 

Enhanced returns and income generation 

Alts have the potential to produce attractive relative returns and yields compared to traditional asset classes. It is important to remember these investments carry their own risks.

 

Diversification 

Adding alternatives that are less correlated with traditional investments within a portfolio of stocks and bonds may potentially diversify risk exposures. 

 

Expanded opportunity set 

Shifts in public-private market capital formation have resulted in a large and growing set of new investment opportunities not typically found in traditional public investment options.

 

Inflation protection 

Alts backed by real asset collateral, (e.g., real estate), have the potential to offset inflation risk to a degree when the collateral has appreciated with inflation. Investments in private credit may offset inflation risk to a degree when their floating rates automatically adjust when nominal rates rise. 

 

Investor risk considerations

Alts investments can vary tremendously in their accessibility and structure, but they typically share several key risk considerations:

 

Greater complexity 

Alts can be complex, requiring specialized knowledge and can add tax complexity. Strategies may use leverage, which has the potential to magnify returns and downside risk.  

 

Limited transparency 

Alts often have fewer regulatory reporting requirements and may not always offer the same level of transparency as traditional public investment offerings.

 

Barriers to entry 

Regulations generally only permit marketing and distribution of alts to sophisticated investors who meet certain qualifications. This generally shuts out investors who fall below the qualified investor requirements. In addition, alts may require greater tax compliance and reporting as compared to traditional public investments, which can be a large administrative burden.  

 

Valuation challenges 

In the absence of a mark-to-market price, alts are often “mark-to-model,” which involves assigning estimated values based on complex financial models. As a result, prices aren’t updated frequently and are subject to appraiser discretion.

 

Low liquidity

Most alts are illiquid and typically can’t be easily bought or sold, making them more suitable for long-term commitments. Depending on the strategy and vehicle type, investors may not be able to redeem the entirety of their investment for multiple years.

 

High minimum investments and fees 

Many alts have high minimum investment requirements and fee structures, such as performance fees and carried interest, compared to traditional investments.

 

Helpful criteria when choosing an alternative investment 

If you’re considering alts for your clients, thorough qualitative and quantitative due diligence is required and includes, but is not limited to:

 

Investment team and firm 

What’s the team’s investment experience? What’s the firm’s culture and areas of experience? How good is their track record across all strategies and services?

 

Investment vehicle strategy and investment process 

What’s the manager’s investment strategy — and how do they use leverage, short positions and derivatives? Does the manager offer strategies that aim to enhance liquidity and bring about greater diversification because they merge public and private assets?

 

Risk management

What risk management protocols are in place to help independently ensure that monitoring is objective and effective? Are risks deliberate, well-balanced and aligned with established investment guidelines?

 

Pricing and valuation practices 

Is pricing separate and distinct from the investment team? Is a third-party valuation agent or administrator used? Are valuation inputs consistent? Is there a formal and comprehensive internal process to assign appropriate values to the investments?

Basic private markets data

 

Item 1: Growth of private credit

 

The private credit market has grown substantially in the years since the Global Financial Crisis. Banks traditionally provided most credit to small and medium-sized borrowers, but the Crisis led to widespread bank failures and mergers and a decline in new bank charters. The remaining banks had to comply with new regulations and, as a result, took on less risk and offered fewer loans to middle-market companies.

 

The private lending market grew to fill this gap. Between 2006 and 2023, global private credit assets under management increased each year, from $176 billion in 2006 to $1,667 billion in 2023. 

 

Hover over each bar in the chart below to view the total global private credit AUM for that year.

Item 2: Private credit’s yields

 

Over the period of its expansion, the private credit market has offered greater yields than high-yield public debt and the leveraged loan market. This higher yield compared to public debt compensates investors for both the greater risk from credit spread and the private assets’ illiquidity.

 

Hover over the graph below to view yield data over time.

Item 3: Private credit for diversification

 

One of the benefits of investing in private credit is that it may help diversify your portfolio. In recent years, private credit has demonstrated a lower correlation to the S&P 500 Index (U.S. equities) and Bloomberg Aggregate Index (U.S. public fixed income) than high-yield public debt and leveraged loans, which are comparable forms of credit.

 

This means that investment in private credit may potentially dampen the volatility of a portfolio.

End of lesson

You now have a greater understanding of the world of private markets and private credit. Don’t forget to review lesson takeaways here.

 

The next lesson will dive deeper into private credit, its opportunities and risks.

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Introduction to public-private solutions

1.1 Introduction to private markets and private credit
1.2 Fundamentals of private credit
1.3 Accessing private credit in an interval fund
1.4 Introducing public-private solutions

Takeaway

Private credit 101:

A guide for individual investors

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The Cliffwater Direct Lending Index was launched on September 30, 2015. Data before this date is hypothetical (back-tested) and based on the methodology established at that time. Adjustments during back-testing aimed to capture a comprehensive universe of securities and simulate the target market or strategy, especially during market anomalies. Back-tested performance provides historical insights but has limitations, including survivorship and look-ahead biases. Actual returns may differ significantly from back-tested results, and past performance does not guarantee future results. Index returns shown do not reflect actual trading activities and exclude sales charges or fees associated with purchasing securities or investment funds tracking the Index. Additional fees and charges may impact performance of securities or funds compared to the Index. Market risks, including financial market fluctuations, liquidity risks, and regulatory risks, may affect the Index's performance. The Index may also be subject to concentration risks if heavily weighted towards specific sectors, industries, or geographic regions.

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Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the interval fund prospectuses, which can be obtained from a financial professional and should be read carefully before investing.

Consider the following risks for the Capital Group KKR fund(s) discussed in this material: The fund is an interval fund that provides liquidity to shareholders through quarterly repurchase offers for up to 10% of its outstanding shares under normal circumstances. To the extent more than 10% of outstanding shares are tendered for repurchase, the redemption proceeds are generally distributed proportionately to redeeming investors (“proration”). Due to this repurchase limit, shareholders may be unable to liquidate all or a portion of their investment during a particular repurchase offer window. In addition, anticipating proration, some shareholders may request more shares to be repurchased than they actually wish, increasing the likelihood of proration. Shares are not listed on any stock exchange, and we do not expect a secondary market in the shares to develop. Due to these restrictions, investors should consider their investment in the fund to be subject to illiquidity risk.

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Bond investments may be worth more or less than the original cost when redeemed. High‐yield, lower‐rated, securities involve greater risk than higher‐rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. The fund may invest in structured products, which generally entail risks associated with derivative instruments and bear risks of the underlying investments, index or reference obligation. These securities include asset-based finance securities, mortgage-related assets and other asset-backed instruments, which may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market's perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. While not directly correlated to changes in interest rates, the values of inflation-linked bonds generally fluctuate in response to changes in real interest rates and may experience greater losses than other debt securities with similar durations. The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds. For example, the fund may purchase and write call and put options on futures, giving the holder the right to assume a long (call) or short (put) position in a futures contract at a specified price. There is no assurance of a liquid market for any futures or futures options contract at any time. Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility. These risks may be heightened in connection with investments in developing countries.

The fund invests in private, illiquid credit securities, consisting primarily of loans and asset-backed finance securities. The fund may invest in or originate senior loans, which hold the most senior position in a business's capital structure. Some senior loans lack an active trading market and are subject to resale restrictions, leading to potential illiquidity. The fund may need to sell other investments or borrow to meet obligations. The fund may also invest in mezzanine debt, which is generally unsecured and subordinated, carrying higher credit and liquidity risk than investment-grade corporate obligations. Default rates for mezzanine debt have historically been higher than for investment-grade securities. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy.

Illiquid assets are more difficult to sell and may become impossible to sell in volatile market conditions. Reduced liquidity may have an adverse impact on the market price of such holdings, and the fund may be unable to sell such holdings when necessary to meet its liquidity needs or to try to limit losses, or may be forced to sell at a loss. Illiquid assets are also generally difficult to value because they rarely have readily available market conditions. Such securities require fair value pricing, which is based on subjective judgments and may differ materially from the value that would be realized if the security were to be sold.

The fund is a non-diversified fund that has the ability to invest a larger percentage of assets in the securities of a smaller number of issuers than a diversified fund. As a result, poor results by a single issuer could adversely affect fund results more than if the fund were invested in a larger number of issuers. The fund intends to declare daily dividends from net investment income and distribute the accrued dividends, which may fluctuate, to investors each month. Generally, dividends begin accruing on the day payment for shares is received by the fund. In the event the fund's distribution of net investment income exceeds its income and capital gains paid by the fund's underlying investments for tax purposes, a portion of such distribution may be classified as return of capital. The fund's current intention not to use borrowings other than for temporary and/or extraordinary purposes may result in a lower yield than it could otherwise achieve by using such strategies and may make it more difficult for the fund to achieve its investment objective, than if the fund used leverage on an ongoing basis. There can be no assurance that a change in market conditions or other factors will not result in a change in the fund distribution rate at a future time.

This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.
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