Private credit has been in the headlines over the past few months, with periodic news about sharp valuation adjustments in certain private credit funds. We think these headlines say less about a systemic issue across the private credit landscape, and more about the importance of manager selection when it comes to allocating to private credit.

And when you see a private credit fund run into trouble, you generally see one or multiple of these common themes, either insufficient diversification, high leverage, weak underwriting, or elevated non-accruals, meaning a rising number of borrowers falling behind on their payments. Now, it might not be all four of these themes showing up, but generally speaking, you’ll see at least one or two of these show up when a private credit fund has to make a big valuation adjustment downward on the value of the loans in their portfolio.

It’s key to understand that private credit is not one market, it’s thousands of individual loans, and as a result, comparing one private credit fund to another can be difficult in the sense that they can have very different returns depending upon how those portfolios are constructed.

Three Things That Matter When Evaluating Private Credit Managers

In terms of what to look for as you’re evaluating different private credit managers, there are three really important things. Number one is seniority in the capital structure. During periods of economic stress, first-lien loans and more conservative managers will tend to outperform managers that focus on lower-credit-quality loans. Second is diversification across borrowers, industries, and private equity sponsors. Concentration risk is not well compensated by markets. And third is how much leverage is being applied to the portfolio. Higher leverage amplifies both yield and losses during periods of economic stress.

Lessons for Investors

While private credit can make sense as part of a retirement portfolio, it isn’t necessarily right for all investors. After all, there is not one single best portfolio, but there’s the portfolio that’s best for you in the sense that it’s matched to your goals and matched to your risk tolerances, and it’s one that you can stick with during the ups and downs that every portfolio experiences. Second, higher yields are not a free lunch. They usually signal higher risk. Third, vehicle design and liquidity terms matter most when markets get stressed, not when things are calm. And fourth, manager selection matters more in private credit than it does in most other areas of your portfolio.

Conclusion

To sum up, private credit isn’t broken, but manager selection is very important, and the cost of weak underwriting can show up fast. Asking the right questions up front is how investors avoid learning that the hard way.

The information provided is educational and general in nature and is not intended to be, nor should it be construed as, specific investment, tax, or legal advice. Individuals should seek advice from their wealth advisor or other advisors before undertaking actions in response to the matters discussed. No client or prospective should assume the above information serves as the receipt of, or substitute for, personalized individual advice.

This reflects the opinions of Focus Partners or its representatives, may contain forward-looking statements, and presents information that may change. Focus Partners’ opinions may change over time due to market conditions and other factors.  Nothing contained in this communication may be relied upon as a guarantee, promise, assurance, or representation as to the future. Past performance does not guarantee future results. Market conditions can vary widely over time, and certain market and economic events having a positive impact on performance may not repeat themselves. Investing involves risk, including, but not limited to, loss of principal. Asset allocation and diversification may be used in an effort to manage risk and enhance returns. However, no investment strategy or risk management technique can ensure profitable returns or protect against risk in any market environment. Private credit and private equity investments may be illiquid and subject investors to a higher degree of risk. Numerous representatives of Focus Partners may provide investment philosophies, strategies, or market opinions that vary. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

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