Investments in private credit have become more popular with the wealth channel. However, private credit loans are predominantly issued as variable-rate debt, contributing to outsized returns relative to other private assets. Could lower interest rates and yield compression for the asset class dampen enthusiasm?
Not necessarily, according to industry experts. For example, private debt strategies like direct lending tend to focus on offering loans to small and mid-sized companies whose credit risk profiles rose along with rapid interest rate hikes over the past few years, according to Aaron Filbeck, managing director and head of UniFi by CAIA (Chartered Alternative Investment Analyst Association). A period of sustained interest rate declines will make these loans less risky while still offering investors attractive returns.
“For investors, private credit still offers an attractive income stream (on a gross basis), and it’s likely that falling rates will de-risk some of these investments as companies are less challenged,” Filbeck wrote in an email.
Private markets research firm PitchBook estimates that U.S. private wealth investors are on track to invest roughly $63 billion in private debt funds in 2024, while globally, private debt investments in the wealth channel have risen by 40% year-over-year.
For example, Edelman Financial Engines, an RIA with $288 in AUM, plans to continue offering private debt investments to clients for whom it is appropriate, according to Neil Gilfedder, executive vice president of investment management and CIO of the firm. While advisors must consider their clients’ risk tolerance, he noted that even in an environment with decreasing interest rates, private credit funds typically come with an illiquidity premium. “Private credit is something we plan to offer in all interest rate environments,” Gilfedder wrote in an email.
Stephen L. Nesbitt, CEO of Cliffwater LLC, an alternative investment advisor and manager that has been operating interval funds focusing on private credit for years, including the largest single private credit interval fund used by retail investors, said lower rates could be both a positive and a negative force in the sector. Since most private loans rely on floating rates, he wrote that interest rate cuts mean a “one-to-one reduction” in overall yields. However, lower rates will likely make the underlying borrowers less financially stressed, reducing the risk of loan defaults.
“Cuts may be short-term pain, long-term gain,” Nesbitt wrote in an email.
According to PitchBook, the U.S. Morningstar LSTA Index serves as a good proxy for the returns that private debt funds can expect. In the first half of 2024, the index posted a 4.4% gain, which puts it ahead of the historic 20-year return average of 5.7% for the full year.
As of July, the yield-to-maturity on newly issued U.S. leveraged loans averaged 9.3%, PitchBook reported.
Like Nesbitt, PitchBook researchers acknowledged that since private debt relies on floating rates to deliver returns, interest rate cuts likely make it less attractive compared to fixed-income products.
However, “despite this slightly less favorable interest rate backdrop, demand has been supported by expectations of a soft economic landing,” they wrote in this week’s report. “More gradual rate cuts by central banks make investors less eager to reduce exposure to one of the few strategies that worked during a period of rising inflation. Higher risk-adjusted returns and distribution rates relative to other private market strategies have also reinforced strong flows to private debt. Lastly, while set to decline in the short term, base rates will no doubt make higher lows than the nil levels that persisted for 10 of 13 years before the March 2022 rate hike.”
Another research firm, London-based Preqin, administered an investor survey in the first half of 2024, supporting this outlook. Preqin found that 46% of respondents planned to maintain their private debt allocations in the long term, while 53% planned to increase them despite lower interest rates.
In addition, Preqin researchers noted that a drop in interest rates would likely mean greater deal flow in private loans used by private equity shops, which would likely offset any modest declines in yields.
According to Nesbitt, as long as financial advisors have a long-term allocation strategy for private credit, there is no reason for them to do anything differently because of the recent rate cut.
However, if interest rates get substantially lower than where they are today, investors will have to readjust their expectations for the asset class, warns Martin Gross, founder and president at Sandalwood Securities, a family office that operates a platform for other family offices and financial advisors to invest with alternative asset managers.
“If, in order to maintain current returns in a lower rate environment, sponsors increase leverage, that might be a cause for concern,” Gross wrote.
