Attractiveness of private credit returns persists despite reduced compensation for illiquidity risks

Private credit, a niche market that offers higher returns due to its illiquid nature, is experiencing significant changes.

According to Marcos Alvarez, head of European financial institutions at Morningstar DBRS, the yield of private credit assets is not solely driven by the illiquidity premium but also by the credit risk premium. This assertion comes as many managers are launching fund structures to replicate the experience of a liquid product, potentially engineering away private credit's competitive edge.

Daniel Haydon, an analyst for equity strategies at Morningstar, suggests that the directional effect on the private credit market seems clear, but the quantum of the impact is not yet known. Increased competition from banks, which have been loosening lending standards, is changing the landscape for investors.

The increased interest from retail investors in private credit assets is testing the market. However, experts argue that private credit's appeal extends beyond its illiquidity premium. Tammy Davies, a partner at Morrison Foerster, stated that the shrinking of the illiquidity premium is eroding one of private credit's key advantages. Yet, in specific segments such as non-sponsored middle market opportunities, opportunistic credits, and esoteric investments, investors are still rewarded for providing capital where others are less willing or able to go.

The sector benefitted from the ultra-low-interest-rate regime after the pandemic. However, higher rates have made traditional fixed income markets offer more attractive yields, potentially diverting some investments away from private credit.

In the face of this competition, prominent providers of private credit funds expected to have significant influence on the private credit markets in the next 12 to 18 months include Deutsche Credit and PGIM. Deutsche Credit, with its focus on German mid-sized companies, and PGIM, known for their approach in non-sponsored private debt among family-run businesses, emphasize stringent covenants and higher margins in mid-market lending compared to private equity-led companies.

Despite these changes, Alvarez does not expect a significant shift of assets from private credit to traditional banking in the next 12 to 18 months. Solvency requirements make it more burdensome for banks to lend in certain cases compared to private lenders.

Interestingly, private credit is gaining traction in New Zealand, adding another dimension to the global private credit market. As the market evolves, it will be interesting to see how these changes impact the illiquidity premium and the overall returns for investors.