How can private debt investors gain from rising-rate pain?

CEO of Raintree Capital expects certain sectors of private credit will benefit from rate hikes

How can private debt investors gain from rising-rate pain?

For investors in the public markets, fixed income included, the double-whammy of inflation and rising interest rates has been painful to say the least. But for some corners of the private debt space, things have been slightly different.

“A lot of portfolios with fixed-income exposure have gotten hit this past year,” says Peter Kinkaide, CEO of Raintree Capital. “We haven't seen much in the way of private debt investments being repriced, or there being downward pressure on their values, certainly not in in lockstep with the public debt markets.”

Kinkaide notes that some private-debt investments come with fixed-rate terms, while others are variable-rate. He expects yields for private debt funds underpinned by variable rates to grow over the coming year and beyond, and investors who are able to participate in the net yields of those funds are poised to benefit.

“For some of those private debt investments that have variable returns, you're starting to see returns going up as they're able to increase interest rates they're charging to their borrowers,” he says.

According to Kinkaide, private variable-rate debt funds have the potential to produce better yields than their public counterparts. Part of that stems from their tendency to reprice interest-rate charges to their borrowers more quickly, as many private lenders originate debt with shorter terms. That enhances the ability of their yields to move in response to central banks’ rate hikes.

“The market is reflating, and we're starting to see that trickle on into the private credit market,” Kinkaide says.

From an underlying risk perspective, Kinkaide says the private debt managers he’s spoken to are seeing a general improvement in the credit quality of their new borrowers. Amid continued inflation heat and growing risks of recession, traditional lenders like Canadian banks and credit unions have scaled back on new loan originations, driving more borrowers into the private credit space.

“Most of what we deal with at Raintree is in the commercial lending realm, and less so the consumer realm and mortgage space,” he says. “I would say those are areas where I'd probably be a little bit more tepid right now.”

As elevated prices and interest rates continue to weigh on consumers at large, Kinkaide expects more difficulty to come for the variable mortgage market. He says funds with exposure to variable mortgages, both private and public, are also likely to be sideswiped.

Recently, Starlight Investments put a pause on distributions for two of its funds specializing in U.S. properties. Its U.S. Residential Fund and the U.S. Multi-Family (No. 2) Core Plus Fund, which have $840 million in combined AUM, are facing challenges as the short-term, are now being stung by the variable-rate mortgages that had been used to finance their purchases.

“The size and pace of interest rate increases has been unprecedented and has resulted in interest rates that are significantly higher than projected at the time the Fund financed its properties,” the firm told investors in notes for both funds. “The significant increases in interest rates have also contributed to an increase in volatility across capital markets, leading banks and other debt providers to reduce their lending capacity while increasing the cost of new loans.”

Another area Kinkaide is seeing pressure is new development finance. “With rates moving so quickly, a lot of developers are scrambling to reassess their project budgets to integrate higher interest costs and greater equity contributions lenders are now looking for” he says. 

Looking across the private debt space, Raintree is seeing continued strength in lending to industries like agriculture, equipment finance, and energy.

“The energy sector is so under-loved right now. There's a certain amount of ESG impact coming into play, and there’s also the volatility of the sector,” Kinkaide says. “But on a risk-adjusted basis, I think there's some really unique opportunities for private lenders in that sector to generate very healthy returns.”