“While we are not predicting a downturn, there is truly little room to go any higher”, says Tingting Zhang of TerraCotta Group and speaker at SuperReturn US West 2020. What risks are private credit players facing in the current economic climate, amid an abundance of dry powder and a potential market downturn? Will private credit managers be able to weather the storm?
Q: Credit spreads have narrowed in both public and private credit investments. How can credit investors continue to generate returns as the asset class matures – and with abundant dry powder sitting on the sidelines?
We continue to see yield compression across all asset classes, and private credit is no exception. With private credit in particular, significant and continuous capital injection since the end of the Great Recession has fundamentally modified supply and demand dynamics in the marketplace. As a result, average credit returns have narrowed across the board.
The investment firms that have succeeded in continuing to generate above-market returns despite these macro headwinds have done so by: staying away from head-on competition; finding and creating investable white spaces in the market; and providing unique value for borrowers. Change is truly the only constant – which means that to succeed, private credit shops must maintain an existential understanding of their unique role in the marketplace and of their differentiation, as well as a relentless focus on delivering value for investors and borrowers alike.
Q: Are you concerned about a market downturn? Do you see any warning signs? How does TerraCotta hedge against a potential market crash?
No matter which phase of the market cycle we are in, it is our job to always be vigilant about preparing for a market downturn and its prospective impact on our loan portfolio. At TerraCotta, we do not attempt to predict market timing. Instead, we focus on understanding precisely the prospective magnitude of value fall in a severe recession, and ensuring we are always positioned to weather worst case scenarios.
We specialise in real estate. Every single loan we book is sized to withstand a third standard deviation recession. Historically, when property values deviate significantly from the historical trend line, either above or below, they have a tendency to regress back to the trendline over time. The further away from the trendline, the stronger the tendency. Throughout our normal course of market monitoring, our observation is that median sales price per square foot of all property types in almost all markets have reached above the second standard deviation, after adjusting for inflation. Today we do see that all markets – whether it be commercial real estate, stocks or private equity – are fully priced. While we are not predicting a downturn, there is truly little room to go any higher.
Q: What do you think a market correction will look like in the current market? What impact do you think it would have on the popularity of private credit as an emerging asset class?
Since the end of the global financial crisis, private credit has been an attractive asset class given its relative seniority in the capital stack, its current income, and its risk-adjusted returns. However, as an institutional asset class, private credit is still in its nascency, with many new entrants and an ever-changing market landscape. A market correction – whether global or not and regardless of the catalyst – would likely test the overall valuation of the underlying asset, and challenge the market’s thinking about the viability of existing multiples (in real estate, this would be the capitalisation rate) that back the current asset value. As a result, one can expect that a market correction would usher in a time of declining asset values and transaction velocity.
Public equity, private equity, and private real estate strategies would be confronted with the same tests – however, compared to these strategies, private credit strategies would have to stand up to their claim of being the “safer” asset class. Private credit investment is quite diverse in its security interest (collateralised or unsecured, real estate vs business assets), lien position (first lien, mezzanine, or hybrid), leverage profile (unlevered or levered, leverage ratio, fund-level vs asset-level financing), interest rate mechanism (fixed vs variable rate, with ceiling or floor), liquidity profile (maturity of the loan, debt coverage), and borrower credit quality, among other factors.
There would no doubt be both winners and losers among private credit managers. Suffice to say, a market correction would put all investment managers to task and test them on their preparedness for a downturn, as well as their determination and ability to work out loans in adverse situations. Hopefully, the industry would gain collective wisdom and develop a nuanced appreciation for the diversity of this emerging asset class.
Q: In a recessionary scenario, will private credit truly be insulated from downturns in other markets?
With a global economy, and given that institutional investors have been scouring every corner of the market for yield, there is no denying that investment asset classes are more closely linked today than ever before. Although private credit is typically considered to have a degree of separation from the public market, the correlation (or lack thereof) will likely be determined by each individual strategy and the investment manager’s aptitude for constructing risk-protected portfolios that are not highly sensitised to market forces. With an in-depth understanding of asset behaviours in recessions, a skilled investment manager knows better not to diversify for diversification’s sake. Instead, they diversify across only the most salient of parameters and concentrate on assets that are safe-havens in a recession.
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Under the spotlight: Dr. Tingting Zhang
Dr. Tingting Zhang is the Founder and CEO of the TerraCotta Group. She oversees the firm’s investment activities and manages portfolio risk. Dr. Zhang heads TerraCotta’s Credit Committee. She also leads the research and methodology agenda at the TerraCotta Lab.