Market Conditions Drive Private Credit to Diversify

Market conditions for financial services firms have been shifting since the financial crisis, leaving private investors and managers increasingly underserved by public equities. Periods of volatility have plagued the market since 2008, driven by geopolitical events, supply chain disruptions, central banking policy, and even a global pandemic.

But more recently, the market has evolved in ways that aggressively drive capital from public to private markets.

Inflation hit a 41-year record high in 2022, interest rates are currently sitting at a 23-year high, Basel III Endgame (B3E), set to take full effect in 2025, is changing the regulatory landscape for banks, and geopolitical instability is growing.

It’s not surprising then that public markets have fallen short of providing meaningful stability and returns, leaving a performance gap that private credit funds are stepping into.

Private investors and managers have rapidly expanded alternative investment strategies into new areas, notably private credit products. In another trend, they’ve hedged against inflation by investing in infrastructure.

We’ll examine these two trends and what they mean for the private investors and managers – as well as discuss ways to stay competitive in the rapidly evolving private credit landscape.

Market factors are reshaping the landscape

Elevated interest rates

Between March 2022 and January 2024, the Federal Reserve hiked interest rates 11 separate times from near zero to 5.25-5.50%, one of the most aggressive tightening campaigns in the central bank’s history.

The result? Fixed income prices have dropped precipitously, driving down the capital value on banks’ balance sheets. This prompted substantial risk sell-off as financial institutions moved to rebalance their portfolios to meet capital requirements.

Historically high inflation

Despite the Fed’s aggressive tightening campaign, inflation climbed to 3.5% annually in March, the highest since 2022 pandemic levels and far higher than the Fed’s target goal of a 2% annual climb.

Inflation’s stickiness has driven up the demand for infrastructure investment, historically seen as a hedge against rapidly rising prices. In 2023 alone, private credit investors raised nearly $9 billion for infrastructure projects.

Increasingly strict regulatory environment

Regulation creep has been forcing banks to tighten lending for years now. As part of a massive regulatory acceleration, B3E is set to take effect July 1, 2025. The goal of this regulation is to lower the volatility of risk-weighted assets by introducing a set of rules that will stiffen the capital requirements for banks.

Once live, banks with $100 billion or more of assets will be held to higher risk-reduction standards, which will inevitably accelerate the flight to private credit as banks further tighten lending.

Private credit funds are exploiting the change, seizing lucrative deals as banks shed loans. Credit Strategic Solutions, for example, purchased $415 million of student loans from Truist Bank earlier this year.

Mark Jenkins, head of global credit at Carlyle Group Inc., told Bloomberg in February he hasn’t seen this volume of loans for sale in decades.

“It is really the first time in 33 years of my history that I’ve actually seen an active flow of deals coming out of banks in a very steady manner as opposed to very episodic,” said Jenkins.

RELATED READING: How Technology and Data Management Are Influencing Banks’ Response to the Basel III Endgame

Private credit as a diversifier

The changing landscape is prompting private credit managers to increase their investments in packaged loans and infrastructure.

Let’s break down each asset type.

SRTs

With synthetic risk transfer (SRT) transactions, banks unload the credit risk of a portfolio of loans, like mortgages, to another investor, typically a credit fund manager.

This allows banks to reduce the capital requirements they must meet under regulatory frameworks. As they offload risk, the amount of capital they need falls.

Meanwhile, private credit funds leverage credit instruments and diversify their portfolios. Moreover, SRT transactions can be tailored to meet a fund’s specific objectives, providing flexibility and potential for higher returns.

However, SRTs can be complex to manage. They come with counterparty risk, legal and regulatory compliance requirements, require custom accounting treatments, and operational flexibility as loan terms can be restructured.

As a result, managers must ensure they have the necessary tech resources to manage SRT transaction risks.

CLOs

Collateralized loan obligations, or CLOs, pool together cash-flow-generating debt securities, primarily syndicated loans with a range of credit risk, and issue tranches of securities backed by this pool.

The riskier the tranche, the greater the expected return.

Since the underlying assets have floating rates, CLOs have served as a reliable haven from the volatility of rising interest rates.

The first CLO ETF launch in September 2020 spurred growth in CLO investing. Over the last six months, AUM in the CLO ETF space increased 86%. US CLO issuances grew 30% year-over-year in Q1’23 at $40.4 billion.

Pooled loans

Pooled loans, made up of loans issued by consumer-facing lenders like SoFi and Lending Club, group a variety of underlying consumer or commercial loans into a single basket.

Hedge funds like Stoneridge are increasingly buying up whole loans from alternative lending platforms and pooling them together as regulatory oversight grows and interest rates persist at historically high levels. In October 2023, SoFi and BlackRock (BLK) partnered on a $375 million personal loan securitization exclusively with BLK funds.

This move offers diversification, access to a broad range of borrowers and industries, and the potential for higher returns.

At the same time, operational challenges associated with these instruments include due diligence complexity, credit risk and audit assessment, and the need for hands-on portfolio management.

RELATED READING: Modeling, Transacting, and Servicing Pooled Assets

Infrastructure

Amid rampant inflation, infrastructure investments have emerged as a favored choice. Due to its long-term nature, guaranteed yield and stable cash flows, infrastructure has historically served as an effective hedge against rising prices.

McKinsey predicts a $15 trillion spending gap on global infrastructure through the end of the current decade. Even in 2022, when many private products saw volume slip, infrastructure fundraising expanded.

Unsurprisingly, given the current environment, we’ve witnessed high-profile acquisitions in this space. Earlier this year it was revealed that BlackRock agreed to purchase Global Infrastructure Partners (GIP) for roughly $12.5 billion. The purchase makes the money manager one of the largest players in the asset class, with GIP managing $100 billion of infrastructure investments.

BlackRock CEO Larry Fink recently told Bloomberg News the market is “in the early part of this infrastructure revolution.”

“This will be one of the fastest-growing areas of our industry over the next 10 years,” read an employee memo written by Fink and BlackRock President Rob Kapito earlier this year.

In short, infrastructure is proliferating in the private credit space. This trend will bring with it opportunities to pursue lucrative returns and secure steady long-term income streams.

However, infrastructure as an asset class can be complex from a regulatory, legal, and operational perspective. This asset class is also illiquid, and demands robust policy around managing investment exits.

Operations and tech challenges of these investment trends

While opportunities abound in infrastructure and packaged loans, diversifying into these assets involves a host of operational changes for firms as they look to scale and grow.

Manual asset servicing becomes inefficient

While Excel can help get you started in managing a few investments, a large portfolio demands appropriate tools. As your fund expands, manual tracking and management becomes overly cumbersome, not to mention risky.

To effectively navigate this space, your technology and operations must be primed to facilitate myriad tasks, like valuations and reconciliations, while ensuring compliance with regulatory standards.

At 500 positions, tracking individual deal terms and conditions is a cumbersome process.

As transaction complexity rises, so do the demands for customized accounting, bespoke reporting, and meticulous audit trails.

Around 1,000 positions, manual data management quickly reaches a breaking point as firms scale. Support and operations staff are generally limited with respect to AUM at firms, making further inefficiency untenable.

To operate seamlessly at scale, a firm should use comprehensive data models pre-loaded with details required for these asset classes to manage transactions.

Data ingestion and analysis become unwieldy

When managing a complex portfolio of packaged loan products, ingesting data files with the underlying loan details from servicers and normalizing them into a single data set is a task that invites manual errors.

One way to minimize the error margin would be to automate data ingestion with a unified data model that can support a variety of loan and borrower data across loan servicers.

Platforms that can intelligently pair records together, support many-to-one matching, and understand the relationships between external parties to run multiple reconciliations at once offer an effective solution.

Reporting needs surge

As investors increase their allocation to private assets, their expectations of fund managers grow beyond simple quarterly reports. Investors are demanding a deeper level of transparency, seeking insights into the details of their holdings.

Unlike public markets, private assets reside in an opaque environment where information about parties and transactions is not always readily available. Consequently, investors lean heavily on their fund manager to provide detailed insights.

Increasingly, investors are demanding mid-cycle updates and customized reports in real-time – and in a user-friendly format. Without adequate tools to fulfil these requests, firms can quickly become operationally overloaded.

For private credit funds, consolidating this data from diverse sources into a cohesive format is challenging. As a result, it’s essential to streamline those processes using available tools.

To remain competitive and address investor expectations, firms must arm themselves with the tools to value, reconcile, and manage these investments and, critically, to remain compliant.

How to brace your firm's operations for these changes

1) Strengthen reporting frameworks: Build comprehensive reporting frameworks that give managers the information they need to manage these assts, and cater to investors’ evolving needs including mid-cycle customized reports. Prioritize the development of flexible reporting systems that can adapt to changing requirements.

2) Streamline data integration: Establish streamlined processes for integrating data from numerous sources into a centralized repository. Implement data governance practices to ensure data accuracy, integrity, and accessibility.

3) Invest in technology: Invest in pre-built technology like Arcesium’s Aquata™ platform that elevates your data infrastructure, offers self-service configurable reporting, and runs pre-built private markets-aware models that keep you on the front lines of your transactions at all times.

Implementing data management systems that can aggregate, analyze, and present data in user-friendly formats while automating audit and governance functions is crucial. This will allow your firm to scale across new assets and positions seamlessly, without adding an unsustainable headcount in proportion to the assets under management.

Is your firm looking to further explore private credit opportunities? Get a copy of our whitepaper on new and growing asset classes to learn more about this trend.