By Erik Sherman

Private credit has become an important asset class for institutional investors. Goldman Sachs, Blackstone, and Ares Management are among the giants recently in the news recently for their activities in the area.

Canadian pension investments are also deeply involved in private credit for some practical reasons. The question is how long that will continue if certain macroeconomic factors —such as high interest rates and a bank pull-back from areas of commercial lending — shift.

Here’s a short summary of how some of the biggest pension plans have invested in private credit (in Canadian dollars):

  • The Canadian Pension Plan Investment Board has 13% of its overall assets in credit, which “consists of public and private credit investments of which $52 billion forms part of the Active Portfolio and $20 billion forms part of the Balancing Portfolio as of March 31, 2023.”
  • The Ontario Teachers’ Pension Plan has 13% of its assets in credit — again, a combination of public and private credit — which as of December 31, 2023, was $38.6 billion.
  • The Caisse de dépôt et placement du Québec has $96.6 billion, with public and private credit, out of its $135 billion fixed income assets as of December 31, 2023.
  • The Alberta Investment Management Corporation had $37.0 billion (28% of total assets) in money market and fixed income, including public and private equity, for the year ending December 31, 2022.
  • Healthcare of Ontario Pension Plan reported in its 2022 annual report, a year-end market value of $3.1 billion in its global credit portfolio.

Of these five, the term “private credit” did not appear in their annual reports ten years ago.

Fueling Private Equity

In the last ten years, growth across the asset type has been about 11% per year, according to Brett Hillard, managing director of GLASfunds, an alternatives investment and operational platform providing financial advisors with direct access to private fund opportunities from private credit to venture capital.

“The growth of private credit has continued to be strong,” Hillard says. “This coincides with the overall growth of private capital. Private credit is the fuel for private equity. There is never a shortage of mismanaged businesses. What we’ve seen over time is the deal sizes in this market continue to get bigger and bigger. Now there’s more direct competition between this and syndicated loan markets.”

“The higher interest rate environment makes it more attractive when they’re trying to match it to their pensioners,” says Ranesh Ramanathan, a partner and co-leader of Special Situations & Private Credit Practice at Akin Gump Strauss Hauer & Feld. “For a long time, they were too low. When the risk free rate was zero, you’re charging 5% or 6%. It’s become very attractive for someone who has a fixed liability.”

The growth owes to a combination of factors. First, interest rates have risen significantly due to central banks battling inflation, increasing return for investments in private credit. Second, in the U.S. market, many banks have pulled back from lending as they have portfolios of loans in currently challenging areas. Those include commercial real estate and so-called zombie companies that can barely pay interest on their loans after fixed and operating expenses. (In 2021, Federal Reserve research suggested that 10% of public firms and 5% of private ones are in this category.)

A third factor is legal. “One of the big issues with private credit in the US used to be a tax issue, ECI — effectively connected income,” Ramanathan says. “A foreigner could not be engaged in lending money to in the US.” The ECI requirements would force them to pay U.S. taxes, driving down income. The Tax Cuts and Jobs Act of 2017 reduced the required levels of taxation, making investment in private credit far more profitable.

Too Good to Be True?

Andrew Grauberg, CEO of ABC Quant, which provides risk management data to institutional investors, says that the opacity of private credit markets should make pension funds a little wary, as many institutional investors have pulled back.

Asset-backed loans “had a huge spike in August 2022 of institutional inflows,” Grauberg says, jumping about 61%. “After September 2022, it was dropping [and is] still going down basically to the same levels of August 2022. They’re realizing it’s not as good as it used to be.”

Grauberg says that there are a number of possible explanations. One could be many institutions have become convinced that private debt might be a large bubble. Another is that some number of third-party lenders are borrowing the money they lend and a “lot of talks now are about leverage for those fixed-income asset-backed loans.”

It would also seem that if, as many investors assume, the Federal Reserve and other central banks start to roll back interest rates, other sources of lending would become cheaper and banks might see less danger in their portfolios, bringing them more fully back to the debt markets. Borrowers might not need private credit anywhere nearly as much.

Because of the opacity, understanding the true risk investment is difficult. Often, traditional market or credit risk analysis won’t show the potential danger that specific stress testing can.