With a handful of tech stocks leading the market rally, equities are historically concentrated. And now that stocks and bonds have grown positively correlated, the bond market isn’t providing the diversification benefit it used to.
So what’s an investor to do?
That’s a question many clients of financial advisors have been asking, and it seems the advisors are honing in on a solution: alternative investments.
According to a recent CAIS-Mercer survey, alternative investments such as private equity, private credit and real estate are among financial advisors’ primary focal points during 2024.
Notably, advisors not only feel that focusing on alts provides their clients with portfolio diversification benefits, they also believe that recommending alternative investments gives them–the advisors–an edge.
Financial advisors are coming to believe that a focus on alts affords them a competitive advantage by differentiating their practice, helping them win new clients and gaining wallet share from current ones.
Chasing Whales
Given the deluge of institutional capital that has flowed into alternatives lately, it should come as no surprise that financial advisors are recommending the strategy to their clients.
Every week that passes seemingly brings news of another institutional investor joining the private credit frenzy. Some recent headlines:
- The $13 billion Sacramento County Employees’ Retirement System (SCERS) has increased its private credit allocation by 25% since 2017. “We’ve actually found a lot to do there. And it’s where we probably find the most compelling opportunities,” said Steve Davis, chief investment officer of SCERS.
- The $70 billion Teachers’ Retirement System of Illinois continues to grow its $12 billion alternative investments portfolio, with $570 million in private markets allocations.
- An S&P Global Market Intelligence survey found that nearly 61% of pension funds, sovereign-wealth funds and insurance companies plan to expand their asset allocation to private credit this year.
When it comes to private credit specifically, the tailwinds are so strong that industry insiders are predicting a secular shift in strategy from institutional investors. According to Blackstone’s chief investment officer, Mike Zawadzki, “pension plans are in the beginning stages of multi-asset private credit.”
Institutional investors are often classified as ‘smart money,’ (not always accurate, but still). It makes sense to follow the smart money into alternative investments, specifically private credit, given that these institutional players often think and behave on multi-year, even multi-decade time horizons.
So if they’re investing in private credit now, that’s a strong indicator that the sector will continue to grow for some time.
What Bubble?
The rapid adoption of private credit as an investment strategy has raised questions about its risks.
We’ve explored the risks of investing in private credit in the past. A key concern on the part of investors is default risk. While this concern is understandable, worries about an imminent spate of defaults may be overblown.
According to the Cliffwater Direct Lending Index, loss rates for direct lending (the primary type of private credit loan) stand at 1.03% as of Q4 2023. That’s far below both high yield bonds (1.49%) and commercial and industrial bank loans (2.3%).
Direct lending’s low loss ratio can be attributed to the strong fundamentals underpinning U.S. middle market companies (the primary borrowers of direct loans). Middle market companies grew revenue by 12.4% over 2023, outpacing companies in the S&P by 5%.
Furthermore, as private credit grows more mainstream, underwriting standards are remaining intact. A concern is that lenders might loosen standards as the industry grows, but that hasn’t happened, according to data from Proskauer.
As the chart above shows, lenders have actually tightened their underwriting standards over the past two years. They are demanding more equity from borrowers and lower earnings leverage in deals, which implies they are making more creditworthy loans (which further implies that loss rates will remain low, assuming no meaningful recessionary pressure).
All Signs Point to Private Credit
Circling all the way back to our financial advisor friends from earlier. Remember, they’re facing tough questions from clients about where to invest capital and how to diversify away from public markets.
Private credit offers diversification and a lack of correlation with stocks and bonds. Plus, one of the primary risks is mitigated by a resilient economy undergirding direct lending performance and encouraging lenders to maintain their underwriting standards.
Those are all positive signs for private credit.
Toss in a double-digit APY (Heron Finance is targeting 10-14% APY net of all fees), and its small wonder financial advisors are following in the footsteps of institutional investors and flocking to private credit.
