Private credit: Is it a bubble, or something your clients can't do without?

It's either a bubble or one of the best investing opportunities for coming years: Even top executives at the same firm have a hard time seeing eye to eye on private credit.

UBS Chairman Colm Kelleher warned in November at a global banking summit in London that he thinks a bubble is forming in the private lending market, which enables investors to loan money to companies outside the banking system. But speaking early last month in an online discussion of investment prospects in the year ahead, Dan Scansaroli, the head of portfolio strategy at UBS Global Wealth Management, said private credit remains a good way to diversify a portfolio away from relying solely on stocks and bonds. That's especially true, he said, for sophisticated investors who are capable of weighing the pros and cons of different investment vehicles and who can also afford to shoulder a little extra risk.

Kelleher's warning about private credit was preceded by similar alarm bells from the investing firm PIMCO, long a leading expert in the bond markets. But the optimists have plenty of good company as well.

In September, Morgan Stanley, citing data gathered by Bloomberg, estimated the size of the private market has nearly doubled to $1.4 trillion in the past three years and predicted it could grow to $2.7 trillion by 2027. Ashwin Krishnan, the co-head of North America private credit at Morgan Stanley Investment Management, noted in an online interview that the yields from the most common form of private credit — known as direct lending — have outpaced those from high-yield bonds since the global financial collapse in 2008. 

One attractive feature of private loans, according to Scansaroli, is that they often come with floating interest rates. This helps ensure their yields stay ahead of inflation. 

"Investors are very interested in it, and we believe that it is a meaningful part of a portfolio," Scansaroli said during UBS's investment discussion last month. "And, you know, it should be a place that they're putting some capital in if they're able to tolerate some of that illiquidity, but it comes with a different set of risks."

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Not created equal
No matter how a given firm rates private credit, virtually all agree that investors can and should take time to learn about it before jumping in. Scott Bishop, a partner and managing director at the Houston-based advisory firm Presidio Wealth Partners, said in an interview Thursday that it's a misconception that all private credit opportunities are a "black box" offering no insight into their benefits and risks.

Bishop said his firm started paying a good deal of attention to private credit during the COVID-19 pandemic. Private lending may have risks, he said. But it seemed a safer bet than high-yield bonds issued by companies that could be on shaky ground at a time of economic uncertainty.

When the Federal Reserve started raising rates to combat inflation, private credit's floating yield proved to be another helpful protection. Bishop said his firm ultimately invested in credit sponsors who were lending money to apartment buildings and hotels — property that could serve as collateral.

"There are huge differences in the type of securitization they are in, how much risk they are willing to take and if they are senior secured so that they are collateralized," Bishop said. "We are very picky about the type of private credit we use."

Out with the 60/40
In a paper released in November, the alternative-asset manager KKR noted that opportunities to invest in the public markets have become rarer as the number of companies listed on global exchanges has decreased by 30% in the past 40 years. Meanwhile, innovations in private markets have made it easier for investors to put their money into alternatives.

For people seeking to generate income, KKR suggests they abandon the traditional portfolio allocation that has investors putting 60% of their money into stocks and 40% into bonds. A better division for the years ahead, according to KKR, would have 15% in private credit, another 15% in private infrastructure and real estate, 40% in bonds and only 30% in equities.

The market for private credit has grown in recent years as tightened regulations on banks have caused many to slow down their lending to private companies. Direct lending and other forms of private credit have several features that make them appealing alternative forms of investment.

Scansaroli noted that private loans pay good yields; certain loans now offer returns well in excess of 12%. He also said creditors in the market tend to be positioned at the top of the "capital stack," meaning they'll be among the first in line to be repaid should a borrower default.

"The key is to focus on experienced managers who are prudent at underwriting, have proven capabilities in turning struggling companies around, or have experience in taking equity ownership," he said in an email Thursday.

Private credit attracted large amounts of money amid the rock-bottom interest rates of the last decades, when many investors proved willing to take a risk on alternatives in return for yields. Scansaroli predicted the market could be in for another boost if the economy shows signs of stalling next year. 

Some existing loans may falter under those conditions, he said. But the fundamentals of higher quality credit are strong.

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"The reason this space has become so popular is because the lending standards for the banks continue to get tighter and tighter," Scansaroli said during the investor roundtable. "And in the process of a slowing-down economy, we expect that more private lenders will be going into the market in order to help private companies grow."

Still not for some
But do all advisors think private credit is a good idea for their clients? Noah Damsky, a principal at Los Angeles-based Marina Wealth Advisors, said he has looked for private credit opportunities for clients and just hasn't found any he likes. Again and again, he ran up against the same objections: Private lending is too obscure, meaning it's hard to gauge the prospects of the companies that are being lent to, and it's too illiquid, meaning it can be hard for lenders to get their money back when they want it.

"The 'reach for yield' before rates increased in the last couple years meant investors were reaching for yield by taking too much credit risk," Damsky said in an email. "This segment of the market can become very illiquid if they become stressed, so we think the asymmetric downside to the limited upside has not been worth the risk."

But for Bishop of Presidio Wealth Partners, there's no reason to look at private credit differently from any other investment opportunity.

"Everything has its pros and cons," he said. "Just be careful about what you're doing."