Credit investing exec at Hamilton Lane sees potential boom for lenders & investors
While skyrocketing interest rates have been a challenge to the public markets, pummelling valuations on both the fixed-income and bond side of the traditional balanced portfolio, it’s also been a gale-force tailwind for at least one segment of the alternative investment universe.
“Everybody's interested in direct lending or private credit today, just given the shift in the opportunity set,” says Emily Nomeir, managing director of Direct Credit Investments at Hamilton Lane. “That shift is probably something many would describe as the ‘golden age of private credit.’”
As Nomeir points out, no discussion around alternative fixed income is complete without an acknowledgment of the abrupt escalation of interest rates from near-zero just two years ago.
With the Bank of Canada’s policy rate now at 5%, she’s seen a seismic shift in the opportunity set for private credit, with lenders seeing more chances to occupy very senior positions in capital structures, provide favourable financing solutions for businesses, and generate expected performance in the double digits.
“One trend that’s been evident in recent years is the growth of strategies like evergreen or semi-liquid vehicles in private markets, which creates opportunities for private wealth investors that have historically had more limited access,” Nomeir says.
Amid the pressure-cooker climate of high inflation and rapidly rising rates, investors have lent more weight to forecasts of recession than they have in years, with the exception of the few months immediately after the first impact of COVID-19. But the economy is proving more resilient than many would have supposed, Nomeir notes, with the actual timing of recession – Will it be early next year? In the second half of 2024? Or even later? – still very much an open question that only time can answer.
“What we've seen so far in terms of a downturn is a slowdown in M&A activity and a pullback in traditional sources of financing – banks pulling back from middle market lending,” she says. “We’re also seeing higher borrowing costs, and lots of concern around volatility, which we've seen in the public markets.”
With higher rates resulting in magnified borrowing costs for businesses, Nomeir says investors are focusing their attention on the risk of defaults. While the prognosis for defaults is likely to get worse before it gets better, there’s also a good reason for investors to pause and take a breath.
“We're coming out of an environment where defaults have been at historic lows,” she notes. “They've started to increase today, but they're generally in line with long-term averages.”
Also worth mentioning, Nomeir says, is the fact that defaults don’t necessarily translate to losses. Translation: default risk is certainly something to watch out for, but what’s really key for investors is maintaining credit discipline even as they navigate and access the current landscape of private credit.
The long-term record of private credit is also something to highlight. Nomeir says its history of offering stability to investors, with some of the narrowest dispersion of returns in both up and down markets relative to other private-market asset classes, has bolstered its reputation as a safe harbour in today’s environment.
“We're seeing opportunities to invest at the top of the capital structure, and generate double-digit performance … but still sort of mitigate some of the risks that come along with investing,” she says.
The recent big bang in the private credit universe, Nomeir says, isn’t just about the growth in size of the asset class, but also in terms of the types of strategies within the space. With options available across the risk-return spectrum, she says investors have greater flexibility than ever to pick and choose their spots based on their investing goals and objectives.
“If you’re looking for private credit to offer safety and yield, there are strategies around senior lending that are extremely compelling today, particularly relative to historical levels,” she says. “In this environment, there are also opportunistic strategies which offer investors access to more junior parts of a company’s capital structure through instruments such as hybrid notes, which include either Holdco notes or preferred equity with debt-like characteristics.”
Those more opportunistic options, Nomeir says, may have a paid-in-kind feature that gives a borrower greater cash flow flexibility while maintaining credit-like documentation and offering the potential for attractive risk-adjusted returns relative to more senior term loans. The continued growth in secondary credit, she adds, creates yet another potential access point for investors with varying risk-return profiles.
“Right now, I think investors have the ability to really pick and choose where they want to play in terms of risk-reward tradeoffs within private credit,” she says.