In the quest for attractive yields, institutional investors are exploring the niche world of private credit. Within this space, emerging managers often promise enticing opportunities. However, while the allure of diversification and the prospect of high returns are tempting, it is critical to assess the risks these investments carry.
Target Returns: A Comparison with Public Markets
A fundamental concern is that the target returns offered by emerging managers in the private credit space may sometimes seem unjustifiable compared to comparable public market rates. Private credit funds led by emerging managers often project returns in the range of 12% to 15%. While this may initially appear attractive, one must remember that these returns are contingent on a seamless execution of the fund's strategy.
Many capital providers underwrite investments at a lower return, assuming that a new manager will make mistakes. For example, an emerging manager presenting a 12% to 15% return may be automatically compared to a 7% to 10% return, assuming a base or downside case from the capital provider. The 7% to 10% return is significantly less attractive compared to a lower-risk debt instrument in the public markets, such as a high-yield bond.
Compared to investments in established public markets, which are backed by years of historical data and extensive regulatory oversight, they may offer similar or even higher returns with arguably lower risks. From an investor's perspective, the question then becomes whether the premium for investing in private credit is sufficient to compensate for its associated risks.
Operational Challenges: Costs and Management Complexity
Specific strategies pursued by private credit funds can be operationally intensive, which can have a substantial impact on the expected returns. For instance, trade finance, small business lending, and venture loans can become costly endeavors, significantly eroding the margin for profit.
1. Trade Finance: This strategy often involves intricate supply chain mechanisms and requires extensive due diligence. The costs involved in monitoring, verifying, and ensuring compliance can escalate quickly, trimming down the net returns. We do not prefer trade finance strategies.
2. Small Business Lending: While potentially lucrative, small business lending requires a keen understanding of local markets and often involves high operational costs in identifying, assessing, and managing borrowers. An emerging manager needs to demonstrate a focus on diligent valuations, proper accounting, and realistic forecasting to attract interest from seed capital providers.
3. Venture Loans: This strategy involves lending to early-stage companies. The risk is high, and coupled with intensive due diligence and ongoing oversight, the cost-to-return ratio can be prohibitive. The space is also becoming increasingly competitive, with numerous new entrants emerging following the collapse of many regional banks that previously served this niche.
Emerging managers, operating as a sole General Partner (GP), may find these strategies challenging to manage effectively, which can impact their ability to meet target returns. Conversely, a team of four or more may raise concerns with the capital provider about the operating expenses of the fund and/or the ability of the management fee to motivate a large team financially.
What we like in Emerging Manager Private Credit
Investing in private credit funds managed by emerging managers can undoubtedly open up avenues for returns and diversification. However, a discerning investor must weigh the risks against the potential rewards. It is essential to assess whether the expected returns adequately compensate for the complexities, operational challenges, and inherent risks associated with these investments.
At Ashton Global, we prefer niche credit strategies related to under-the-radar segments of markets where the manager has a unique skill set. Healthcare and sale-leaseback strategies also attract strong demand from investors. We prefer credit strategies that generate equity returns, as opposed to those that yield credit-like returns. Lastly, managers must be aware of the tax implications of their approach and consider these when presenting to investors.
