The private credit question the Bank of Canada left unanswered

Colin Kilgour is a principal at Kilgour Williams Capital and has been active in the Canadian credit and structured finance market since 2001.

A pedestrian walks past the Bank of Canada in Ottawa, on June 10.The Canadian Press/The Canadian Press

Canadian investors and banks now have an estimated $500-billion of exposure to private credit lending, most of it directed at the United States, underwritten by non-bank institutions and held beyond the public eye. In a market that has expanded this quickly, careful scrutiny is warranted.

The concerns the Bank of Canada has raised are real, and they are concentrated in specific corners of the market. Painting the entire asset class with a single brush would obscure the very real differences between strategies that are working through this cycle in very different ways.

In the United States, the pressure has been concentrated among large asset managers lending to private-equity-owned businesses, particularly in the software industry. Data tracked by providers such as Preqin shows that alternative lenders routinely write cheques between US$20-million and US$650-million to these borrowers, replacing what would once have been traditional broadly syndicated bank loans. When one of those large loans experiences trouble, the impact on a concentrated portfolio is meaningful.

In Canada, the concern has been different. Several real estate credit funds have faced liquidity shortfalls, driven by a mismatch between the term of their underlying investments – typically five years or longer – and the frequency of investor redemption rights, which have been offered on a monthly or quarterly basis. When investors requested their capital back, the funds could not liquidate their positions fast enough to meet those requests.

The Bank of Canada is right to watch these dynamics.

Both problems are real and worth watching. But both are specific to a subset of the private credit market, not the whole of it. According to the Cliffwater Direct Lending Index, which tracks the broader direct lending market, the asset class has generated positive returns in 19 of the last 20 years, including through the pandemic and the recent interest rate cycle. Global investment flows into private credit remain strong. The investor value proposition of uncorrelated, attractive yield remains solid. Manager selection and due diligence are the difference between capturing that value proposition and being caught in the funds that make headlines.

Below the mega-fund tier and outside of concentrated real estate strategies, another segment of private credit operates on very different terms. It funds direct loans to small- and medium-sized businesses. These are the companies that the U.S. Small Business Administration reports represent 43.5 per cent of U.S. GDP. They’re also the businesses that traditional banks have retreated from because the size of the loans no longer justifies the cost structure of a large bank.

Strategies focused on this end of the market share a set of structural features that put them in a different risk category from the strategies drawing scrutiny. Portfolios in this segment tend to hold hundreds of small loans rather than dozens of large ones, which limits the impact of any single default.

The loans are typically short-duration and fully amortizing, generating regular principal repayment that funds redemptions without asset sales. Leverage is often modest or unnecessary because the underlying yield stands on its own. And the term of the investments is matched to the term investors are offered – no gap between what the manager has lent and what the manager owes.

These are different strategies with different risks, and the current public conversation is not distinguishing between them.

Canadian investors evaluating a private credit allocation should look for four things: diversification across borrowers and industries, modest use of leverage, an investment term that matches the term of the underlying investments, and an investment thesis that is easy to understand.

They should be cautious about the opposite: concentrated portfolios, strategies focused on a single industry or a single geography, term mismatches between the fund and its investments, and fund managers who get paid fees by the borrowers whose loans they are underwriting.

The Bank of Canada’s role is to watch systemic risk, and it is doing that job. The industry’s role is to be transparent about the strategy behind the label. If private credit is going to serve Canadian investors well in the years ahead, that transparency is what will earn the market’s trust. That work starts with the language we use and with the questions investors know to ask.

The private credit question the Bank of Canada left unanswered - The Globe and Mail