What do high inflation and rates mean for private credit investment?

In an era marked by high inflation and rising interest rates, the landscape of private credit investment is undergoing significant transformation. While these economic conditions present challenges, they also unveil unique opportunities for private credit investors and borrowers alike.

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A nascent, fast growing asset class

Private credit is a relatively new market in Australia despite its strong growth offshore, particularly the US. Over the last six years it has become more established as an attractive asset class for investors to allocate to and as an alternative source of funding for businesses.

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While private credit is still a smaller market than traditional lending and equity, it plays a crucial role in supporting the economy. It acts as a vital bridge during periods of economic uncertainty, filling funding gaps and enabling businesses to navigate challenging market conditions.

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High-rate periods further cement private credit’s growing market share and role in economic growth because during periods of high interest rates, private debt offers borrowers:

1. Flexibility: Private credit providers often offer more flexible lending terms and structures compared to traditional banks. This flexibility can be particularly attractive during high-rate periods when businesses need tailored solutions to manage their financing needs and mitigate the impact of rising costs.
2. Speed and accessibility: Private credit providers can often provide funding more quickly than traditional banks, which is crucial in a high-rate environment where timing can significantly impact borrowing costs and investment opportunities.
3. Diversification of funding sources: Companies look to diversify their sources of capital to reduce reliance on any single type of funding. Private credit becomes an appealing option, especially when traditional sources are constrained or less attractive due to high rates.

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The result is that during changing capital conditions, such as those we currently see, high quality borrowers seek out private credit funds like Keyview to provide finance through transitionary periods in their businesses. This has translated into increased borrower demand.

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On the investor side, we’ve also seen a surge in investor and financial advisor interest and allocation, especially over the last year.

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Enhanced income potential for investors

For investors, one of the most compelling advantages of private credit funds in times of higher inflation is the potential to offer enhanced income compared to traditional fixed income or dividend-based investment strategies.

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Private credit investments are often shorter term than traditional fixed income products and have the potential to earn an interest margin above a floating base rate. This allows investors to benefit directly from interest rate rises, offering a strategic hedge against inflation. This is particularly relevant in the current "higher for longer" inflationary environment, as variable rates have the potential to protect investors from the eroding effects of rising prices on fixed returns. Additionally, the shorter duration of private credit allows for the timely reinvestment of capital into new, strategically structured loan agreements that incorporate tight lender protections tailored to the prevailing market conditions.

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Diversification and resilience

We see the diversification benefits of private credit as being particularly valuable in today's market environment. With lower correlations to traditional asset classes, like equities and conventional fixed income, private credit can significantly reduce overall portfolio volatility.

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Additionally, the emphasis on secured lending and stringent covenants in private credit agreements offer an added layer of security, safeguarding investments against borrower defaults. Active private credit lenders take a hands-on approach compared to traditional banks which means they closely monitor and therefore manage their investments. This proactive involvement allows for a deeper understanding of the borrower's business, potentially leading to better risk management and enhanced investment security.

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Investment selection remains crucial

The core of any credit investment strategy is capital preservation with a meticulous evaluation of how to safeguard investor capital in potential adverse scenarios. There is a natural symmetry between what we see as good credit investments and businesses or assets poised to excel in environments of high inflation and interest rates. When evaluating private credit investment opportunities, we focus on downside protection, assessing elements such as collateral backing, consistent cash flows, robust profit margins or the capacity to transfer costs to consumers without diminishing demand.

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Industries that have shown notable resilience include:

1. Consumer finance providers – The industry has benefited from similar thematics to the private credit industry and has appropriate collateral bases to support a growth financing package;
2. Natural resources - Producers have been benefiting from commodity price inflation, notably gold producers[MB1]  who have benefited from the counter cyclical nature of the underlying commodity; and
3. Residential real estate – The hard asset backed nature of the investments protects capital through economic cycles.

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Whilst these industries generally fair well during a rising rate environment, as a firm we view opportunities on a case-by-case basis searching for pockets of the market where we can find outsized returns for the underlying risk.

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Attractive alternative for borrowers

While the benefits for investors are clear, there are also material advantages for borrowers in the private credit market in comparison to traditional financing alternatives.  Private credit investments can be customised to support the specific growth goals of a borrower, incorporating tailored safeguards within the loan agreement to mitigate the lender's exposure to the borrower's business or sector-specific risks. This represents an attractive alternative to commercial bank financing which may offer rigid “one size fits all” terms.  

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For companies seeking to fund growth, private credit can also offer an attractive alternative to equity financing, which requires giving up a portion of ownership and control, potentially at significant discounts to where existing shareholders value their business depending on market conditions.

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The outlook is bright

High inflation and rising interest rates are driving a significant shift to private credit investment. Private credit stands out as a flexible and accessible alternative to more constrained traditional lending, offering tailored solutions to meet the evolving needs of borrowers. As businesses navigate the challenges of a high-interest rate period, the strategic importance of private credit will likely continue to grow, cementing its role in supporting economic resilience and development.

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This adaptability, combined with the potential for enhanced income and inflation protection for investors, positions private credit as a critical allocation in investment portfolios. The emphasis on secured lending, stringent covenants and active management further enhances its appeal, providing both stability and growth opportunities.

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Disclaimer:

Keyview has prepared this information based on general and factual nature only. All information has been prepared without taking into account your objectives, financial situation, or needs. Because of this, we recommend you consider, with or without the assistance of a financial adviser, whether the information is appropriate for you. 

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