IG Private Credit – Shifting Benefits up the Risk Spectrum

Private credit has been one of the fastest-growing segments of the financial system over the past 15 years. The asset class, as commonly measured, totaled nearly $2 trillion by the end of 2023.¹ While it remains a small fraction of the broader fixed-income landscape, private financing solutions continue compare favorably against bank and public alternatives. 30 years ago, companies would work with banks to access financing – as those solutions became more commoditized, private credit stepped in to offer a unique partnership and deliver bespoke financing solutions tailored to specific borrower needs. Borrowers’ willingness to pay a premium to comparable publics for the speed and certainty of execution, unregistered status (particularly important for cross-border issuers), and customizable structures was promptly met by yield-hungry lenders.

Much of private credit’s growth to date has been concentrated in direct lending – and as AUM has ballooned, it has captured a lot of headlines around excessive risk taking under the name of “private credit.” Thus, many of the broad characteristics assigned to private credit are features of direct lending – sub-investment grade rating, floating rate obligations and most notably, illiquidity.

Investment grade (IG) private credit, an often overlooked $200 billion segment of the asset class, carries meaningfully different characteristics. While still benefiting from the issuer preferences of execution and customization, the space also offers stronger covenant packages compared to publics. These features drive a meaningful portion of the spread premium received relative to public credit equivalents, suggesting a “complexity” premium where investors are required to navigate several additional factors not present in public markets (Figure 1, 2 and 3).

Figure 1: IG Private Credit versus Private Credit

Source: LGIM America. For illustrative purposes only.

In addition to execution and customization, privacy can also play a major role in the willingness to pay a private market premium. The incredibly well capitalized National Football League (NFL) is one of the largest borrowers in the investment grade market. The NFL’s preference for borrowing from private markets is also influenced by their desire to maintain financial privacy. Unlike public markets, which require extensive disclosures and adherence to SEC regulations, private credit allows the NFL to keep its financial details confidential. This discretion is particularly valuable for the NFL and more than justifies a premium to public comparables.

If not standard agency ratings, what?

Aside from being fixed rate and meaningfully more liquid than sub-IG counterparts, IG private credit markets benefit from a mostly uniform ratings methodology akin to public markets. As many market participants are beginning to realize, the broader conversation around private credit has focused high-level distinctions such as direct lending rather than ratings distinctions in-line with public market convention. But this evolution makes sense – early users of the market were more levered companies who could not land favorable terms with their banking relationships. 
However, most of the market has continued its evolution towards manager preferences as opposed to industry standards. To date, many managers focus more on their internal ratings or risk/reward trade-off assessments. They frequently try to take the public ratings out of the analysis and focus on a more flexible internal rating criteria and/or measure risk as leverage per unit of spread or return per unit of leverage.

Major opportunity in the IG segment

Historically, IG private credit has been a favored investment for US insurance companies seeking diversification through unlisted, high-quality debt assets. While this market segment has been outpaced by aforementioned categories, investors are starting to identify a massive opportunity in high-grade debt. This is timely, as diversification in high-quality assets has become increasingly important with public indices becoming more and more concentrated.

Currently, there is a tremendous appetite for capital – we talk about the “Global Industrial Renaissance”– data and compute, power for AI, energy transition – which suggests the real economy needs massive amounts of capital. Apollo views private credit as a $40 trillion market, a majority of which is investment grade. McKinsey ran a similar analysis and found “the addressable market for credit could be more than $30 trillion in the United States alone.”1

Some of biggest public capital market participants are looking for diversified financing, flexibility and high-quality partners who can bring speed and certainty such as Anheuser-Busch Inbev SA, Intel and Air France. These are investment grade, name brand firms with plentiful access to public markets yet turn to the private markets looking for differentiated solutions. Asset-backed financing (ABF) is also anticipated to play a crucial role in this growth, offering a diverse range of investment opportunities backed by tangible and financial assets such as residential mortgages, aircraft leases, auto-financing, fund finance and receivables.

Shifting private credit benefits up the risk spectrum

At LGIM America, we are looking at an economy resembling a patchwork of winners and loser – and given valuations, credit markets appear most vulnerable to disappointment. This comes at a time where asset allocators are seeking to meaningfully increase private credit exposure (over 40% of investors seeking to increase allocations in next 12 months).²

Risks on the lower end of the market are beginning to materialize. Fundamentals are deteriorating in more levered portions of the credit markets and calls of “complacency” have begun to grow louder. And although defaults remain low, the recent Pluralsight saga has highlighted the risks of sub-IG floating rate debt issued during the COVID zero-rate environment.³ Further, there are other challenges unique to private markets such as evaporating fund-level liquidity. The sub-IG world was built around loan-to-own and locked up capital affords very little ability to "get out" before asset maturity. This wasn't a problem until high rates upended some of the usual capital flows across credit.

Investors should be prepared for a more nuanced landscape—one where opportunities exist, but the margin for error has narrowed. In such a world, flexibility will be key to navigating the shifting narratives that continue to shape markets. In the private credit context, investors may want to consider moving up the risk spectrum into investment grade private credit to capture the potential benefits of the asset class with more favorable exposure to leverage and certainty of cashflows.

Figure 2: NAIC-1 Spreads (A-AAA) above public comparables

Source: LGIM America. Data as of April 30, 2024. For illustrative purposes only.

Figure 3: NAIC-2 Spreads (BBB) above public comparables

Source: LGIM America, Bank of America. Data as of April 30, 2024. For illustrative purposes only.

1. McKinsey.
2. Preqin investor Outlook H1 / H2 2024.
3. Private Debt Investor - Report: Talks about the twisty Pluralsight saga near conclusion. 

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