Everywhere I go nearly everyone is getting excited about the prospects for private credit. The asset allocation pitch is perfect. Institutional investors need to diversify their fixed-income portfolio away from an overreliance on government bonds and higher-grade corporate bonds. That’s helped by the fact that the big banks have increasingly curbed their mainstream private credit operations – loans to privately owned corporates.

And of course, the world is increasingly going private, avoiding public markets, so the shift to private credit is simply following the trend.

And if all that wasn’t good enough, there’s the yield pitch, which consists of the classic, ‘where are you going to get more than 500 basis points over traditional bonds?’ Answer private credit, be it within structured finance such as collateralised loan (CLOs) or debt obligations (CDOs), leveraged loans or even direct lending.

Excitable capital

There are of course challenges, not least where to invest in all this excitable capital. Only last week I was talking to one veteran private debt specialist who said they were absolutely expecting to smash past a multi-billion dollar fundraise but that the real problem was finding enough serviceable niches to deploy the capital. As we chatted everything from litigation finance through to SME lending and trade finance popped up in the conversation.

So private credit is hot, even though everyone and their aunt thinks that a slowdown at best and a recession at worst is on the horizon, which would presumably push up levels of borrower defaults.

But here’s the paradox. The one market in the world where private credit has been a mainstream investor option for many years, with proven track records and a clear line of sight to defaults is in the doldrums. No prizes here for guessing what I’m referring to here – the niche in UK-listed lending funds. Over the last decade, we’ve seen a profusion appear that engage in all kinds of private credit, be it loans, structures, or any other variety of debt instrument.

The first big wave consisted of direct and peer-to-peer lending funds which raised billions. Then we had a wave of CLO funds, who also raised billions. Next up we had a small bunch of infrastructure lending funds – more billions. As the niches proliferated, we saw ever more exotic strategies including lending to regional banks or sustainable bonds for energy companies looking to improve their ESG credentials.

Closed-end problem

Along the way of course there were the usual ‘challenges’. Defaults on peer-to-peer loans to SMEs spiked and funds went into runoff. Portfolio companies also started to worry investors – note the price drift at sector giant BioPharma Credit (BPCR ) as one of its US-listed borrowers has had to reschedule loan repayments.

Regulatory changes didn’t help as IFRS 9 forced fund managers to adopt rigorous – some might say over rigorous – valuation metrics for loans and borrowers that might be struggling, necessitating sometimes drastic haircuts on portfolio marks.

Yet the London loans market continues to exist and at the last count, there are still over 20 lending funds with a total market value of over £7bn. And yet here we come to what cynics such as me might regard as a paradox. Can these listed private credit funds interest anyone in their strategy and raise fresh capital? Can they heck!

Hoist a private fund on the sticker, add a well-known name from the world of private alternative assets on the label and tens of billions await your sales person, but mention a listed closed-end fund and everyone runs for the hills. Take Blackstone which is running a large amount of money for its various lending strategies but is now winding up its structured finance fund.

Or Victory Park, a well-established niche direct lender which is doing very well stateside with its private credit operations but is slowly winding up its listed lending fund VPC Specialist Lending Investments (VSL ),  despite what I regard as an impressive track record at above average yields.

As we descend into the smaller funds, the failure of lending as an asset class on the London public market – in money-raising terms – becomes obvious. RM Infrastructure Income (RMII ) for instance has long had a very well-run and impressive little fund which has now decided to go into run-off after toying with the idea of combining with GCP Infrastructure (GCP ).

Talking of GCP, its fellow GCP Asset-Backed Income (GABI ) fund also recently called off a merger after its shareholders revealed they were less than enthusiastic. It’s now winding down its loan book.

What what about Riverstone Credit Opportunities Income (RCOI ) fund which has very successfully pivoted away from its traditional old energy loans book and turned itself into a nice, sustainability bonds specialist, lending money to businesses to beef up their ESG credentials? It can’t get above the $100m asset level for love or money.

Or EJF Investments (EJF ) with its specialist lending into community and local banks which also has a great track record – again, it can’t raise the capital to scale up and has instead decided to issue zero dividend preference shares to beef up its loan capital.

Discount trouble

And I’ve also not mentioned the other elephant in the room. Discounts. Without exception, shares in these lending funds are trading at very high discounts to net asset value (NAV). According to Numis, across the 23 funds, the average discount is running at 17.6% with some funds on even bigger discounts: EJF Investments at 32%, GABI at 40%, Riverstone Credit at 20%, GCP at 39% and ICG Longbow UK Property Debt (LBOW ) at 44%.

These discount levels would be understandable of course if the loan books of these funds were in deep trouble, churning out historically low yields in a rising rates new world order. But they are not in such an obviously bad place. Again, using Numis data, the average net yield is now 9.8% per annum which is probably a yield higher than the ones I’m hearing quoted by private credit fundraisers for new funds.

And much, if not most of these loans are floating rate structures – Sequoia’s loan book is for instance running at just under 50% floating rate and it’s one of the biggest funds in this space even after its substantial buyback programme. As for NAV write-downs using Numis data, the average across all the funds year to date NAV performance is a gain of just under 8%-11.6% for structured finance funds, 6.2% for direct lenders and 4.2% for infrastructure debt.

One last observation. The key winning pitch for many new private credit funds seems to be to find lots of niches where you can get above-average returns. The London funds absolutely tick this box: specialist infrastructure, specialist local bank lending, sustainable energy loans. Yet apart from one potential new fund buying distressed debt, I’ve not heard of a single putative listed private credit launch in London for more than two years.

The real problem here is scale. Too many of the funds are small and institutional asset allocators increasingly want to deploy hundreds of millions into these listed funds. In the specific direct lending, real estate debt and structured finance space I count just four funds with market values above £500m – Twenty Four Income (TFIF ), BioPharma Credit, GCP Infrastructure and Sequoia Economic Infrastructure Income (SEQI ) – and just two (Biopharma and Sequoia) above £1bn.

Rates rescue

I’ll finish with one last thought. I can entirely understand the bear’s case: too many sub-scale funds, the probability of rising defaults as a slowdown looms, and not enough extra yield over risk-free asset returns. That’s a potentially dangerous, toxic brew which has evidently made the sector deeply unloved – and no doubt encouraged most of the managers to abandon London and switch to marketing new private funds.

But if interest rates do start to come down in 2024 or 2025, then maybe an average discount of a bit under 20% and yields just shy of 10% might begin to seem very attractive to the jaded buyer of newly minted private credit funds looking for a bargain?

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