Opportunities in Private Credit: Stepping in as Banks Step Out
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View Membership BenefitsAs banks pull back from many types of lending, demand for capital is outpacing supply, providing the best potential opportunities in private credit since the GFC.
Fallout from the most rapid rise in interest rates in four decades may be creating the best environment for private credit investors since the global financial crisis (GFC).
Banks are retreating in the face of liquidity constraints, regulatory scrutiny, and higher cost structures. Sharply higher interest rates have raised borrowing costs, removing excess liquidity across the economy and prompting more depositors to move savings into higher-interest accounts. Additionally, the first major reform in bank regulation in over a decade – if passed – would take effect next year and increase capital requirements at a time when bank capital is already at a premium.
As bank retrenchment creates a void in lending markets, private capital has been able to step in, providing a stable and longer-term source of funding to banks while also aiding banks in reducing the overall size of their balance sheet.
Amid these shifting dynamics, it is crucial to make two important distinctions when assessing the private market opportunity set.
First we must distinguish between the existing stock of credit and future credit origination. We expect the current interest rate environment to put pressure on much of the existing stock of credit – particularly corporate and commercial real estate-related credit that was originated in an environment of abundant supply and low interest rates. Yet bank retrenchment has reduced competition in many markets, creating new origination opportunities and a stronger position for the remaining lenders.
Second, we must differentiate between technical pressures on banks facing liquidity challenges, and fundamental pressures affecting the assets themselves. Consumer balance sheets have proven remarkably resilient, having locked in historically low fixed mortgage rates, and many companies have refinanced higher-interest-rate bonds by issuing low-coupon, long-term, fixed-rate bonds. Thus, while banks face liquidity pressure in a variety of asset-based finance areas backed by both consumer and non-consumer collateral, the fundamentals of the assets themselves are actually quite solid. In contrast, fundamental weakness is becoming apparent in areas of corporate credit, where highly leveraged borrowers are straining to meet floating-rate interest payments or looming debt maturities. We believe the stress will worsen and spread as fiscal policy turns contractionary and the economy softens, which can create opportunities for private credit investors.
Real estate markets also face unique challenges: $3.6 trillion of commercial real estate (CRE) loans are maturing in the U.S. and Europe through 2025, many of which may not qualify for extensions.1 Compounding the issue of bank retrenchment has been similar declines by other lenders typically relied upon for financing, such as publicly listed mortgage REITs and CMBS issuers, which face their own fair share of challenges. As a result, we expect the opportunity set in real estate-related credit to remain outsized relative to real estate equity over the investing cycle.
INVESTMENT IMPLICATIONS
As demand for capital outpaces supply, investors stand to benefit from the combination of liquidity-driven opportunities in private credit, as well as more complex transactions that solve capital structure challenges for corporate and real estate borrowers. Critical to this is a broad definition of the opportunity set in private credit, which looks across specialty finance, real estate and corporate credit. Patience is also key, because many of these opportunities will arise over the coming months and years as asset owners face uncertain monetary policy, potential slowing growth, and elevated geopolitical tensions. In this nascent stage of the stress cycle, we favor raising liquidity while preparing to take advantage of valuation overshoots and dislocations.
Specialty finance. Specialty finance – collateral-based loans to consumers and small and midsize businesses – gained critical mass after the GFC, filling the liquidity gap left as banks retrenched across sectors, especially in residential mortgages. Many specialty lenders, however, rely on short-term, low-cost bank lines of credit (known as warehouses) to fund the loans they originate and on functioning securitization markets to sell into. Amid recent liquidity pressures, regional banks have cut warehouse lines of credit, while securitization markets have been muted – underscoring specialty lenders’ need for diversified sources of stable capital.
We see opportunities for private credit investors to provide capital in three ways: to banks – which are still originating loans, though on a far smaller scale; to nonbank lenders; and directly to borrowers. Our highest-conviction sectors are residential mortgage credit, solar and home improvement lending, equipment finance, and aircraft leasing. Pricing has become more attractive as available bank capital shrinks and demand for specialty lending rises – the beginning of what we believe will be a secular trend.
The sector represents an exciting opportunity, in our view, with potentially higher risk-adjusted returns than other private asset classes, such as private corporate lending and equities. Amid today’s uncertain inflation and interest rate trajectories, the shorter-duration of the assets may lessen volatility, with principal paying down over time rather than in a bullet payment at maturity. In addition, the wide variety of loans and borrower types offers potentially deep diversification, historically generating low investment return correlations to markets, the economy, and one another.2
Senior corporate loans. Corporate leverage has soared, most notably in the market for senior floating-rate loans, which has tripled in size since the GFC to nearly $3 trillion.3 In particular, we expect to see growing stress in the private segment of the loan market. Many of these borrowers are smaller, highly leveraged companies that have less access to capital markets and are more vulnerable to economic downturns. Sharply higher interest rates may leave many of these below-investment-grade borrowers struggling to meet higher debt-service costs.
This fundamental stress for borrowers may contribute to a broader liquidity shortfall which, in our view, likely intensifies as private debt fund managers (known as direct lenders) that invest in senior loans are forced to remove their nonperforming loans from the collateral pools that banks lend against. As a result, we anticipate a growing number of managers may be compelled to sell underperforming credits at a significant discount as they seek to upgrade credit quality, maintain a target yield distribution to investors, and avoid lengthy and time-consuming restructuring processes.
As traditional sources of liquidity contract, opportunistic credit managers can step in to fill large liquidity gaps and demand wider spreads and stricter covenants. We anticipate growing opportunities for investors to either purchase these loans at a discount or to refinance companies directly with more flexible loans and capital structures.
Commercial real estate. The CRE market is the most severely dislocated it has been since the GFC, yet fundamentals outside of the office sector have largely held up thus far. To be sure, the current dislocation derives from the capital markets. Rising interest rates have compressed valuations, induced ongoing financial market volatility, and curtailed liquidity in public and private debt and equity.
Private credit opportunities are emerging, spanning performing to nonperforming credit in both public and private debt. Importantly, the current dynamics are providing lenders an opportunity to originate and acquire loans secured by higher-quality collateral, with stricter loan covenants, at lower loan-to-value ratios with a higher all-in return potential.
Within performing credit, we’re seeing an immediate surge in transitional lending, or loans on projects in lease-up, redevelopment, and construction. Transitional loans currently generate high single-digit to low-teens returns with modest and in some cases no leverage. We also see banks selling performing loans at attractive discounts to manage liquidity and capital ratios and get ahead of future potential problems, and selling what we would call sub-performing loans or those likely to struggle to repay at maturity.
We have also observed a growing need for rescue capital both at the asset and holding company level. This is creating attractive opportunities to provide bridge capital in the form of preferred equity and mezzanine debt.
CONCLUSION
As private credit investors, this is the environment we’ve been waiting for. The unprecedented pace of interest rate hikes and resulting volatility are providing abundant potential opportunities in the liquid public markets now, and private opportunities are beginning to materialize in market areas where underwriting became lax. The next few years will be great vintages, we believe, across the private opportunity set for a wide range of investor objectives. With demand for capital outstripping supply, investors won’t need to take large risks, in our view, to generate compelling returns.
1US CRE maturity data: Morgan Stanley; UK and European CRE maturities: JLL.
2Preqin as of 30 June 2023
3S&P LCD as of 31 December 2022
DISCLOSURES
Global Financial Crisis (GFC) refers to the period from December 2007 to June 2009.
Real Estate Investment Trust (REIT); Commercial Mortgage-Backed Securities (CMBS)
All investments contain risk and may lose value. Private credit involves an investment in non-publically traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in distressed companies (both debt and equity) is speculative and may be subject to greater levels of credit, issuer and liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be engaged in restructurings or bankruptcy proceedings. Diversification does not ensure against loss
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2023, PIMCO.
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