Investments in Private loans have become more popular with the wealth channel. However, private equity loans are primarily issued as floating-rate debt, contributing to high returns compared to other private assets. Can lower interest rates and yield compression for the asset class dampens enthusiasm?
Not necessarily, according to industry experts. For example, private debt strategies such as direct lending tend to focus on providing loans to small and medium-sized companies whose credit risk profiles have increased along with the rapid rise in interest rates over the past few years. , according to Aaron Filbeck, managing director and head of UniFi. by CAIA (Chartered Alternative Investment Analyst Association). A period of sustained falling interest rates will make these loans less risky while offering attractive returns to investors.
“For investors, private credit still offers an attractive income stream (on a gross basis) and it is likely that rate cuts will not jeopardize some of these investments as companies are less challenged,” Filbeck wrote in an email.
Private market research firm PitchBook estimates that US private wealth investors are on track to invest approximately $63 billion in private debt funds in 2024, while globally, private debt investments in the wealth channel have grown 40% from year to year.
For example, Edelman Financial Engines, an RIA with $288 in AUM, plans to continue to offer private debt investments to clients for whom it is suitableaccording to Neil Gilfedder, the firm's executive vice president of investment management and CIO. While advisers must consider their clients' risk tolerance, he noted that even in a falling interest rate environment, private loan funds typically come with an illiquidity premium. “Private lending is something we plan to offer in all interest rate environments,” Gilfedder wrote in an email.
Stephen L. Nesbitt, CEO of Cliffwater LLC, an alternative investment advisor and manager who has been operating interval funds with a focus on private credit for yearsincluding the largest private credit span fund used by retail investors, said lower rates could be both a positive and negative force in the sector. Since most private loans rely on floating rates, he wrote that lowering interest rates means a “one-for-one reduction” in overall yields. However, lower rates are likely to make the underlying borrowers less financially stressed, reducing the risk of loan default.
“Cuts can be short-term pain, long-term gain,” Nesbitt wrote in an email.
According to PitchBook, the Morningstar LSTA US Index serves as a good indicator of the returns that private debt funds can expect. In the first half of 2024, the index posted a gain of 4.4%, which puts it ahead of the 20-year historical average return of 5.7% for the full year.
As of July, the yield-to-maturity for newly issued U.S. loans averaged 9.3%, PitchBook reported.
Like Nesbitt, the PitchBook researchers acknowledged that since private debt relies on floating rates to deliver returns, falling interest rates are likely to make it less attractive compared to fixed-income products.
However, “despite this slightly less favorable interest rate backdrop, demand has been supported by expectations of a mild economic slowdown,” they wrote in this week's report. “More gradual rate cuts by central banks make investors less eager to reduce exposure to one of the few strategies that worked during a period of rising inflation. Higher risk-adjusted returns and distribution rates relative to other private market strategies have also fueled strong flows to private debt. Finally, while they are set to fall in the near term, base rates will undoubtedly be lower than the zero levels that persisted for 10 of the 13 years before the March 2022 rate hike.
Another research firm, London-based Preqin, administered an investor survey in the first half of 2024, supporting this outlook. Preqin found that 46% of respondents planned to maintain their private debt allocations over the long term, while 53% planned to increase them despite lower interest rates.
In addition, Preqin researchers noted that a decline in interest rates would likely mean greater deal flow in private loans used by private equity shops, which would likely offset any modest decline in yields.
According to Nesbitt, as long as financial advisers have a long-term strategy of distributing private credit, there is no reason for them to do anything differently because of the recent rate cut.
However, if interest rates get significantly lower than they are today, investors will need to readjust their expectations for the asset class, warns Martin Gross, founder and president at Sandalwood Securities, a family office that operates an office platform other family and financial. advisors to invest with alternative asset managers.
“If, in order to maintain current returns in a lower rate environment, sponsors increase leverage, that could be a cause for concern,” Gross wrote.