The evolution of investment-grade private credit

Episode notes

In part three of our InvestorExchange private credit series, Liz Perenick, head of portfolio management for investment-grade private credit, profiles how the asset class has changed, how it differs from other parts of private credit, and much more.

Key topics:

2:15 – Liz’s background in investment-grade private credit

3:10 - What is IG private credit (and how has it evolved)?

5:15 – Who accesses this asset class?

7:05 – Liquidity and valuations

10:45 – Sourcing IG private credit deals

12:15 – Outlook for investment-grade private credit

14:15 – Public/private convergence

15:00 – Potential risks in investment-grade private credit

16:45 – Liz Perenick, beekeeper
 

Transcript

Liz Perenick: Folks really saw how well the asset class performed, how resilient the covenants were in terms of mitigating downside risk. And, I do hope that we'll continue to see that discipline. It is an area where we are quite different than direct lending. That market does tend to have a lot more competition in terms of competing on covenants. But that is an opportunistic asset class where folks are looking to hit home runs. We are just looking to continue to clip those coupons. And we do have that discipline in the past, but that is something as other folks get involved in the market, it's something that we'll need to pay attention to.

Sonali Wilson: Hello and welcome to episode three of our private Credit Wellington Investor Exchange. This three part mini series explores the evolution and expansion of private credit markets from a niche post GFC solution to a dynamic, multi-trillion dollar ecosystem. Featuring insights from veteran OG portfolio managers that helped shape their respective areas of expertise. Today we're digging into investment grade private credit, which is rapidly emerging as a compelling alternative to public fixed income, potentially offering higher spread premiums, stronger covenant protections and lower historical loss rates. Driven by robust investor demand and a growing addressable market across corporates, asset base and infrastructure areas, it provides tailored financing solutions for high quality borrowers, while enhancing portfolio diversification and providing liability driven and retirement income strategies. I'm your host Sonali Wilson, platform leader for Wellington's private credit platform. I'm joined by Elisabeth Perenick, head of portfolio management for investment grade private credit. There is no more interesting individual to lead us through this dialogue than our 25 year market practitioner. Welcome, Liz.

Liz Perenick: Hi Sonali, it's great to be here today.

Sonali Wilson: So, Liz, before we dive into the evolution of investment grade private credit. I love to talk about people's origin stories. How did an individual that started as an actuary, I believe, end up as a portfolio manager for investment grade private credit?

Liz Perenick: Well, it is a little bit of an interesting story, but perhaps not so different than others. I actually did start off as an actuary inside of an insurance company. One of my last rotations was, believe it or not, pricing private placement transactions, doing those valuations. During that time, I was actually able to sit in on some investment committees, do some deals, and after that, I decided to turn the page and become a private placement investor.

Sonali Wilson: And the rest is history, as they say. We touched a little bit in the introduction on that evolution of private placements. Maybe you can just help us level set. What are we talking about when we talk about investment grade private credit. Most people think about private credit and automatically think about middle market direct lending. This isn't that. How is it different?

Liz Perenick: So it's a great question. There's definitely a lot of terminology out there. And very often folks might not even be talking about the same thing. So just to level set, I would say that if you hear private credit, you may well be hearing somebody talking about direct lending, middle market lending, which is very different from investment grade private credit or private placements or private debt. Sometimes you might hear it called as well. So for investment grade private credit, we're really talking about a market that's focused on investment grade corporations or credits that are large, they're credit worthy BBB- or better in terms of how they're rated. And the asset class as a whole is actually more of a core asset class. We like to call that core plus plus. It's an enhancement to investment grade public fixed income. It's more focused on income generation, capital preservation, and a core asset to back liabilities. On the private credit side, that's a little bit more of an opportunistic asset class. Obviously the yields are far greater. But it is riskier and it does serve a different type of a asset class in terms of the assets and the purpose that folks are looking to invest in and the returns they're looking to get.

Sonali Wilson: Is that the same thing as the private placement market? How have things changed in the last 25 years?

Liz Perenick: I think that one of the biggest things is just the words that we're using today. So investment grade private placements have been around for decades. In the past, though, it really has been an in-house expertise at very large typically US life insurance companies. So investment grade private placements have come to mean any type of transactions that are privately negotiated, typically investment grade, fixed rate bonds. These days, they can cover ABS transactions, corporate deals, joint venture types of projects, and infrastructure debt as well.

Sonali Wilson: Quite a broad universe of underlying collateral types. But you've also talked a little bit and you've hinted at sort of the expansion beyond insurance companies who are originally investing in the asset class. So who's using this asset class today and kind of what role does it play?

Liz Perenick: It's an interesting question because it is quite different than when folks hear about direct lending, middle market lending to lower the low investment grade types of companies. Private placements, even the main part of infrastructure debt, these transactions are typically being done and lent to investment grade corporations or entities or deal structures. So these assets are typically thought of by investors as an extension to an investment grade public fixed income strategy. They're looking to enhance what they're already able to do in the investment grade fixed income market. So the primary focus really is on income generation and capital preservation. But with three extras to it: more relative value in terms of spread or yield, better diversification. And because these were really originally meant to be buy and hold, longer term assets, we very often are benefiting from downside protections or provisions in our documents, which are bespoke. They're different for every deal and every transaction. But the purpose of these are basically meant to keep these companies investment grade in terms of defining financial limitations or limits or maximums on the companies or the situations themselves and/or requiring and forcing prepayment if they're unable to keep those types of metrics and keep them investment grade, or to the extent there are external types of changes, such as changes of control or other types of credit events that may happen.

Sonali Wilson: And so Liz, you touched on a thread there about investment grade private credit being more of a buy and hold asset class. Is there liquidity in this market? Can you trade it?

Liz Perenick: It's a great question. And it's something that, you know, I've heard secondary traders basically say the market is as liquid as it needs to be. We have to remember that this asset class, in its kind of origin and its DNA, was meant to be bought and held to maturity. Folks wanted to be able to depend on the higher coupons on the diversification and the downside risk protection for the entire life of that instrument, and basically were pricing and modeling their liabilities, knowing that they would have those investment streams behind it to back it. So typically these are purchased and they're held and not traded. So that said, you know, it would be very difficult to go out and try and construct a portfolio in the secondary market because the folks that are investing in these securities typically but for issues, downgrades, fallen angels and the like, really do want to hold them to maturity. That said, there is a secondary market, just by way of reference, that annual total issuance on the primary deal fronts about 100 billion. There's probably only about 1 to 3 billion, however, that trades in that secondary market. There are a handful of traders out there. There are transactions that do trade. More often than not, those might be fallen angels. So it's quite easy to get rid of and sell on that secondary market anything that it's distressed or fallen angels. But I would say just because it is a supply constrained market, to the extent folks are looking for some liquidity and might want to sell something in that secondary market, it might actually be quite easy to sell that, given that folks on the primary side are very often have their allocation cut back and really just can't even get enough from the market itself.

Sonali Wilson: So there's liquidity if you need it. But these don't trade in the public market. So there's not a daily price. How do you think about valuing these types of securities?

Liz Perenick: That's another good question. And it is something that is a little different than when you hear about direct lending or private credit valuations. The valuations for these transactions quite frankly is a lot more transparent. We basically price our transactions the same way you might price a public fixed income instrument. So that big part of that discount rate really is, and especially now, that Treasury rate. So that is the biggest part of the discount. On top of that, we are adding a public market comparable spread. And then we're adding that illiquidity premium on the top of that to get the discount rate. Most folks in this market are typically matrix pricing their portfolio. Most players in the market are insurance companies. They do intend to hold these to maturity. And rather than looking for individual prices, they are looking to mark their portfolio to market. As the market is evolving, as we're seeing interest from other players and also looking to put these into non separate account, non-insurance types of vehicles, the market is moving towards a daily individual pricing. We think that that's important. And we've chosen to actually have that third party pricing for all of our pricing. Those secondary traders that trade in the secondary market, they are well aware of all the primary transactions that are happening to the extent there is that secondary trading that's happening, they are in that market as well, and they are now pricing an ever increasing amount of securities, facilitating kind of the growth in the market and the interest from non-insurance participants.

Sonali Wilson: So, Liz, as the market grows and evolves and the users continue to expand, you have to be able to source the deal volume. Who's selling investment grade private credit. Where do you buy it? And are there different markets in which you can transact?

Liz Perenick: Yeah, it's a great question. And it really is a differentiator out with different participants. There really there's a lot of different places that you can source deals. That said, this is a relationship driven market, and it's very important to have been in the industry and to have a wide variety of deal sources. There is a syndicated market out there in terms of bankers, very large, well known banks that act as intermediaries and as part of their capital markets team offer investment grade private placements to companies that the banks might lend to. So there is a well-developed market in terms of these bankers, bringing deals to folks. Most people do in fact source their deals from that market. But there are a handful of players out there that are able and do have other types of relationships where they can source deals from. There are some folks that might solely look to their own origination for their deals. There are other folks that look to do some of that in that syndicated market and combine it with their own origination, but there's also a lot of partnering and club deals that are going on in the market now. And I think that's one of the big sources of growth of the market that we're seeing are deals that are getting done more in these type of club situations, where folks are looking to partner with other folks to get deals done.

Sonali Wilson: As I pick up on the thread of our entire conversation, a lot's changed in the investment grade market. How you originate deals, the types of underlying collateral or opportunities that are out there. What's most exciting as you go forward?

Liz Perenick: I think for me having been in the market, you know, 20 plus years, there really has been an evolution. That said, you know, the reason that this market got started was for all of these deals that just didn't quite fit into a box, weren't public, the issuers might want to keep their information confidential. They might not have had two ratings. They might want to issue in multiple currencies. And so that flexibility in the market has really been the genesis for a lot of different and diverse types of situations being able to come to our market, be it ABS, types of structures or infrastructure debt or even sports teams or royalties and other types of transactions that we see. And I think what's been interesting is we've seen growth, both from the issuer side, as more folks have found out about this market and understand that there are ways that they can issue in another market out there that can be more flexible than public markets. But I think also just in terms of, you know, having had this insurance background and seeing what a great asset liability matching tool this is, an income enhancing opportunity without that type of capital risk that you might find in below investment grade investments. We're seeing a lot of new folks that want to invest in the asset class, too. And so as a result, we're seeing perhaps some shorter-term liabilities, folks that are looking for shorter-term investments in the market. But we're also seeing pensions and other folks that also want to have that longer term. And I think that that variety in terms of the investor appetite that's out there in conjunction with just getting the asset class out there and having folks more knowledge about knowledgeable about it, we are definitely seeing from both a demand standpoint as well as supply, just a lot of more innovation and outright growth and I think opportunities as well.

Sonali Wilson: Do you think that will ultimately lead to even more convergence between the public and private market? As folks become more aware that this is an option out there?

Liz Perenick: I think it's something where typically there's been a very small amount of overlap in terms of public issuers issuing in our market, maybe 10% - 15%, but very low. I do think we're going to see more interest in terms of joint venture types of projects and even companies that might issue in public markets. So I do think that they will be part of that growth. And we'll have a lot of different types of opportunities going forward.

Sonali Wilson: We've talked a ton about the opportunities and all of the exciting areas to potentially expand. With opportunities always comes some risk potentially. What are the things that keep you up at night?

Liz Perenick: I think it's always an interesting situation when you have a lot of demand. I do think the market will continue to be supply constrained. Historically, there's been an incredible amount of discipline since this has been a core asset, something that's been matching liabilities. A good, decent part of insurance companies’ general account. And there's been a great amount of experience just in terms of that book and how the book performed during the global financial crisis. Folks really saw how well the asset class performed, how resilient the covenants were in terms of mitigating downside risk. And, I do hope that we'll continue to see that discipline. It is an area where we are quite different than direct lending. That market does tend to have a lot more competition in terms of competing on covenants. But that is an opportunistic asset class where folks are looking to hit home runs. We are just looking to continue to clip those coupons. And we do have that discipline in the past, but that is something as other folks get involved in the market, it's something that we'll need to pay attention to. And I think folks that are looking for investment managers should really be underwriting folks and looking for folks that have that type of commitment to keep those covenant packages strong, pick the right type of credits that are appropriate for a buy and hold illiquid type of asset class. So while I do think there's going to be more opportunities going forward, increased competition and a change in complexion in terms of participants could put some pressure on that. But I think with the right investment manager, you should be able to continue to have the type of performance that we've been able to see in the past.

Sonali Wilson: I appreciate you saying that. And a lot of what I'm hearing is just that need for steady hands. And so I'd like to maybe close on something a bit more personal. As we think about having steady and safe hands in you, Liz. A little birdie has shared with me that one of your many hobbies outside of work is keeping bees and one would think that to do that well, you actually do need to have very steady hands. Tell me more about this hobby, kind of how it came about, and would love to understand if there's any carryovers into your investment philosophy, that are that are impacted by that hobby.

Liz Perenick: Well, I'll, I'll draw perhaps an obvious parallel. I do think that as a fixed income credit investor, you need to definitely be a little bit more risk averse. You're always concerned about the downside scenario and mitigating risk. That, in terms of personal safety is first and foremost, especially when you're dealing with bees and trying to take their sweetest prize of honey. So preparation, having a plan, sticking to the plan, knowing that there might be surprises, but keeping that type of steady hand in uncertain types of events is definitely a carry over in terms of how to effectively and safely get that honey from the bees and keep them not too angry.

Sonali Wilson: What makes it even sweeter, if you will? It's been clear in our chat today that the investment grade private credit market is rapidly evolving to serve new investor types and provide access to different kinds of transactions. Thanks for joining me on the Investor Exchange to walk through this. It's been great to hear from a longtime expert in this space. Once again, Liz Perenick, head of portfolio management for investment grade private credit. Liz, thank you so much for being here.

Liz Perenick: Thanks, Sonali. It's been fun.

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