The Liquidity Advantage of Investment Grade Private Credit

Over the past decade, private credit, particularly direct lending, has generated higher returns than most other comparable asset classes. Lenders have been yield-hungry while borrowers have been willing to pay a premium for the speed and certainty of execution, agility, customization and looser terms that private lenders offer. Direct lending amounts to roughly $800 billion, or about one half, of the total private credit market. Thus, many of the broad characteristics assigned to private credit are features of direct lending—a sub-investment grade rating, a high floating rate coupon, and, most notably, illiquid.

Given lenders typically hold these loans until maturity or a refinancing event, the absence of a liquid secondary market for many private credit instruments is not surprising. However, investment grade (IG) private credit, an often-overlooked segment of the asset class, offers a somewhat unique experience. Historically, IG private credit has been a favored investment for US insurance companies seeking diversification through unlisted, high-quality debt assets. On top of the traditional private illiquidity premium, IG private credit offers premiums for understanding more complex deal structures, newer issuers and relative size versus public markets. These premiums, historically averaging between a 50-100 basis point spread to public equivalents, have seen a recent increase as more borrowers turn to the IG private credit market in response to stricter bank lending conditions following the banking crisis in the spring of 2023.

With a significantly expanded opportunity set within private credit more generally, the “liquidity” consideration of the liquidity premium has left some investors weighing the risks of accessing a premium while potentially locking up capital. While the investment grade segment of private credit may not be as liquid as public markets, IG private credit dominates the secondary market landscape. One primary dealer is shown below with IG at 84% of volume from 2018-2023.

Figure 1: IG private credit volume by rating

Source: Seaport – Private Place Reg D breakdown covers 2018-2023 with $6 billon+ traded over period.

So, why is this?

The perception of illiquidity is driven by the extreme demand from long-term buy and hold investors that dominate the IG private credit market. Most limitations on liquidity stem from bondholders lacking an interest in selling—stated simply, it is easy to sell but very difficult to buy.

We estimate that the secondary private credit market trades approximately $3 billion per year. It is relatively concentrated in a few of independent brokers with round lots of $10-50 million seeing the lowest transaction costs. Given the relatively opaque nature of private markets, familiarity with the markets themselves often drive liquidity. However, the number of holders, credit quality, trajectory, sector, covenants, jurisdiction, currency, relative position size, etc. also contribute to each deal on a case-by-case basis.

As a result, a vast majority of all trades are initiated by sellers making a portfolio adjustment. For example, some of today’s insurance companies are actively rotating out of coal exposure.

The investment grade advantage

Inclusive of standard illiquidity premia across markets, additional trading costs can range from 3-20 basis points on a spread basis and include compensation paid to a broker (seller only) and additional premia as determined by the buyer. Trades can be executed quickly within a matter of days while others may need to be worked by the broker for 30 to 60 days.

Given the potential for an extended execution period, any hyperactive private portfolios will likely be suboptimal. But given the upfront premium at purchase, alpha via trading activity becomes much less important.

Thus, liquidity concerns are most prominent in periods of distress—which is true of any asset class. Even for credits at risk of downgrade, IG names carry an advantage. While liquidity can certainly become constrained for credits appearing to be at risk of falling below IG, at times, liquidity can actually improve for distressed IG credits as certain workout funds value the control covenants can provide.

Looking ahead

The investable universe of private markets is rapidly growing and evolving. Our team has identified several observable megatrends that are in our view already reshaping private markets, creating both risks and opportunities. In private credit, we anticipate meaningful increases in digital infrastructure, alternatives and transmission utilities. As primary markets evolve, one can expect secondary markets to expand alongside.

Disclosures

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