Despite new macro environment, CEO remains constructive on private credit

It’s become relatively firm macroeconomic consensus that both interest rates and inflation will rest higher post-pandemic than they did pre-pandemic. The zero interest rate policy (ZIRP) and disinflationary trends we saw in the 2000s and early 2010s are unlikely to persist. Instead most economists expect that we will continue to see elevated rates of inflation and interest rates sitting in more of a ‘neutral’ zone. It’s an environment that should be more conducive to public fixed income assets and somewhat less-favourable for so-called “alternatives.”

Yields resting at higher rates should benefit public fixed income — which had been almost completely maligned to the role of capital preservation under ZIRP. A higher cost of capital should be a headwind for private equity and real estate assets, which thrived when money was cheap. Some have even suggested that the ‘liquidity premium’ that private credit products enjoyed relative to public fixed income has shrunk enough to make private credit products less attractive to institutions.

Arif Bhalwani takes exception to that argument. The CEO and Managing Director of Third Eye Capital accepts that we’re in a different regime with regards to both inflation and interest rates. Nevertheless, he argues that private credit allocations can be beneficial to institutional asset managers in this environment, for the nature of their returns, the somewhat bespoke nature of some products, and for attractive growth and yield prospects in the long-term.

“When you look at long-term studies, most of which have been published in the US, you see that in direct lending markets there’s a liquidity premium that has persisted between three and five per cent,” Bhalwani says. “Historically, you see the highest liquidity premium when you have periods of very high market volatility, especially when there’s reduced availability of capital from more traditional lending sources. And that’s where we’re at in the market today.”

Bhalwani notes that due to higher mandated capital requirements and renewed risk aversion from traditional lenders like banks, there is a paucity of capital on the market now. Non-traditional, private market lenders are therefore able to attract returns and yields at far higher rates than they’ve seen in recent years.

That is not to say private credit should replace public credit allocations entirely. In fact, Bhalwani rejects the idea of a false dilemma between the two asset classes. He argues instead that they can compliment one another inside of institutional portfolios. Private credit, he says, can be built out with bespoke structures that suit the specific needs of a pension fund of institution. That allows managers to track and adjust for specific idiosyncratic risks that an institution may want to avoid.

The return profile of a private credit security, Bhalwani says, can also help protect against volatility-induced behaviour. Because pricing is less frequent and therefore less subject to intra-day volatility managers are less susceptible to making bad decisions, something that Bhalwani says even the best investors can do.

“The people who manage money for pensions are still human, so behavioural biases are always going to play into their decisions,” Bhalwani says. “When you see prices moving around on the screen sometimes, especially if those prices start gapping to below where your risk limits are, it can compel knee-jerk reactions.”

Bhalwani emphasizes that despite the less-frequent pricing in private credit products, there is a great deal of rigor that goes into their pricing. He argues that the price is often more based on the performance of the underlying asset rather than in speculative trading. As a private debt manager Bhalwani also says he can get information directly from the businesses he lends to, resulting in fewer “information asymmetries” than you might find in the public credit market.

While Bhalwani sees contemporary macroeconomic forces as conducive to long-term private credit performance, he advocates for a ‘horses for courses’ approach, where the specific advantages of private credit are deployed by asset managers to complement what they get from their other asset allocations.

“Private credit is not really an absolute substitute for the 40 per cent in the traditional 60/40 asset mix. I think private credit is suitable when investors can handle the illiquidity,” Bhalwani says. “In a fixed income sleeve you’re going to use private credit in areas where you might take longer duration risk. The idea of smoother returns is crucial when we talk about these products for institutional investors. Pension funds’ primary concern is long-term stability so they can meet their liabilities. I think that private credit’s smoother return curve allows investors to plan and act based on long-term strategies rather than short-term fluctuations.”