Executive summary:
- The concept of private lending dates back to ancient times, where it was used to protect value during times of economic hardship.
- Private credit can help fill the gap in traditional lending that often exists during periods of stress, offering lenders access to a diverse range of investment opportunities.
- We believe a fund-of-funds approach in private credit is best equipped to mitigate risk and protect value through diversification, professional management, active risk management, and strategic allocation across a broad spectrum of private credit opportunities.
When looking at the increasingly complex structure of corporate lending in the present day, it can be easy to lose sight of the purpose of private credit and its lasting value to investors.
Lending is not a new concept. Even at the dawn of civilization, the necessity to protect the value of crops or livestock existed, for both the borrower (farmer and livelihoods) and lenders (e.g. providing seeds).
The same is true today. What may have been lending to farmers in prior millennia now takes the form of small-to-medium sized businesses, ranging from coffee shops to hospitals. Crucially, while the world might be different, the principles behind effective lending remain unchanged, with many lessons lenders can learn from the past.
1. Stringent due diligence and underwriting
Private credit typically involves rigorous due diligence and underwriting processes. In ancient times this would include knowing the farmer’s line of work and risks extensively, as well as their personal financial situation.
In the present-day lenders maintain these principles, conducting in-depth assessments of the borrower's financial health, business operations, and risk profile. This thorough vetting ensures that only borrowers with strong creditworthiness and stable financial backgrounds receive funding, reducing the likelihood of stress (such as default) during a credit shock.
The response of new private credit deals and fundraising to a credit shock is not as consistently negative as the response of leveraged-loan and high-yield bond issuance
2. Close relationships and monitoring
In ancient times, being a lender was not just a financial transaction, but a relationship requiring support and networking in times of stress. Lenders would often be widely known members of society and play a vital societal function.
Today, these values remain the same. Lenders need to maintain regular communication with borrowers and closely monitor their financial performance and business conditions. This relationship-based approach allows lenders to identify potential issues early and take proactive measures to support the borrower, such as restructuring loan terms or providing additional support, thereby preventing defaults.
Effective lenders, like in the past, aren’t afraid of getting into the weeds and familiarizing themselves with the needs of their client’s business. This is why private lending is a preferred choice of capital when economic times are more complex for businesses, such as during the early phases of Covid-19-led lockdowns.
New private credit lending did not show the same drop as high-yield bond and leveraged-loan issuance in March 2020, and also remained more stable in subsequent months.
3. Tailored loan structures and covenants
Private loans in ancient times were customized to fit the specific needs and circumstances of the borrower. For example, the farmer could borrow seeds and repay with a portion of their harvest as opposed to returning like-for-like seeds. Similarly, today, tailored loan structures can include flexible repayment terms, covenants, and other provisions that help diverse borrowers manage cash flow and financial challenges more effectively. This flexibility reduces the risk of default by allowing borrowers to navigate periods of financial difficulty without breaching loan terms.
Private debt credit losses fall below high-yield bond losses and closer to leveraged loans.
Fund-of-funds approach
Diversification, like lending, is not a new concept. Lenders in ancient times did not just lend seeds to one farmer, they would lend different types of commodities to individuals across the region – not putting all their seeds (or eggs) in one basket!
While thankfully more sophisticated, our fund-of-funds approach adopts similar values in diversification. Our approach in private credit is designed to mitigate risk and protect value through professional management, active risk management, and strategic allocation across a broad spectrum of private credit opportunities. These features collectively help in maintaining value during times of stress by reducing concentration risk, managing liquidity, and emphasizing investments that provide downside protection.
Why private credit protects value in times of stress
During periods of economic stress, both lenders and borrowers can benefit significantly from private credit. For example, if a farmer in ancient times experienced a meagre harvest, a lender might be able to meet the shortfall and extend the timeline of repayment, while potentially recognizing other assets (such as unused seeds) as repayment. This could spare a farmer from ruin while preserving the existing lending agreement.
For borrowers in the present day, similar flexibility can be shown from lenders. Private credit offers flexible financing solutions that are often unavailable through traditional banking channels. This flexibility can be crucial in times of financial uncertainty, allowing businesses to secure the capital they need to sustain operations or pursue strategic opportunities. Borrowers can negotiate terms that are better tailored to their unique needs, often gaining quicker access to funds compared to conventional loans.
For lenders, private credit provides an opportunity to achieve attractive risk-adjusted returns, especially in a challenging economic environment. Since traditional lending may contract during periods of stress, private credit can fill the gap, offering lenders access to a diverse range of investment opportunities. Russell Investments’ a fund-of-funds approach can enhance these benefits by pooling investments across various private credit strategies.
Private credit and the breadth of options available can create the impression that it is a daunting, inaccessible asset class. However, as we have illustrated with examples from the ancient world, this couldn’t be further from the truth. The values behind effective lending are simple, having stood the test of time and will continue to as the industry grows and evolves.
If you wish to learn more about Russell’s private credit capabilities, please visit our private markets page.
Disclosures
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
This material is not an offer, solicitation or recommendation to purchase any security.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
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