average investment > Private Credit Investment Strategy in the Era of The Great Deleveraging

Private Credit Investment Strategy in the Era of The Great Deleveraging

Introduction to Private Credit Investment

The aftermath of a 15-year expansionary monetary policy, coupled with the recent surge in interest rates, has ushered in a rare investment opportunity in the realm of private credit.

Understanding Private Credit

Private credit, also known as private lending, constitutes an asset class encompassing loans, fixed income securities, and structured investments.

It aims to deliver higher yields with lower overall risk when compared to equity investments.

Investors in private credit essentially lend money to borrowers in exchange for a fixed rate of return, often in the form of interest or preferred returns, without holding equity ownership or participating in potential upside.

Distinguishing itself from publicly traded credit or fixed income investments, private credit is illiquid and typically targets a higher relative return.

Investment Strategy

Over the past decade and a half, global financial markets have enjoyed a period of historically low interest rates and generally accommodating monetary policies.

During this era, debt was cost-effective, and borrowing was readily accessible. As a result, until mid-2022, equity investments generally outshone credit as the more attractive asset class.

The equity risk premium, which measures the expected additional return from investing in equities over treasuries, maintained one of its widest spreads in over two decades.

In essence, for a significant portion of the preceding economic cycle, fundamental indicators suggested that credit as an asset class was comparatively less appealing than equity.

However, the past 12-18 months have witnessed a resurgence of higher inflation, unseen in over 30 years.

Consequently, the Federal Reserve has had to reverse its previous stance, rapidly raising interest rates and initiating quantitative tightening to remove liquidity from the market.

This abrupt policy shift has unsettled markets, resulting in broad dislocations, heightened strains within the financial system, and the potential for a liquidity crisis.

This scenario presents both a risk to the global economy and simultaneously offers one of the most compelling environments for credit investments in a generation.

The Dynamics of Leveraging and Deleveraging

Analogous to a balloon inflating with air, the affordability of borrowing costs driven by expansionary monetary policies inflates asset prices and escalates leverage, indicating increased debt within the system.

However, as these policies are reversed, and the air is released, borrowing contracts, and debt must be repaid.

To illustrate this phenomenon, consider a real estate investor who acquired a $100 million apartment building in the fall of 2020.

At the time, they might have opted for a bridge loan for the purchase, enabling them to borrow up to $75 million (a 75% loan-to-value ratio) at a 3% interest rate.

Now, roughly three years later, as the loan approaches maturity, the investor can only secure a $55 million loan (a 55% loan-to-value ratio) with a new interest rate of 6% due to the altered lending landscape.

Even assuming the property has performed well without issues, the change in the lending environment necessitates an additional $20 million in equity for refinancing.

Considering that the investor originally injected $25 million (25% of the initial asset value), this additional $20 million in new equity represents an approximately 80% increase.

Imagine if homeowners had to come up with cash to bolster their equity (pay down their mortgage) by a comparable amount—many would likely find it challenging.

Additionally, the interest payments on the loan will increase by nearly 50%, diverting a substantial portion of the free cash flow that previously contributed to investor returns toward servicing monthly interest payments.

This ongoing process of rising borrowing costs, more conservative lender requirements, and reduced availability of debt is precisely what we are witnessing today—a phenomenon we refer to as “The Great Deleveraging.” While it poses potential distress for borrowers, it concurrently presents enticing opportunities for credit investors.

Conclusion

In the era of The Great Deleveraging, private credit investments emerge as a promising avenue for investors.

The confluence of rising interest rates, stringent lending conditions, and shrinking debt availability has created a landscape ripe with potential.

Credit investors have a unique chance to navigate this dynamic environment, seizing opportunities as borrowers grapple with the challenges of deleveraging.

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