In private credit space, granular private credit offers particularly attractive risk-adjusted returns and a global, scalable, technology-driven opportunity for institutional investors. Access to this asset class, traditionally controlled and retained by banks, is currently constrained by traditional formats, namely privately structured regulatory capital (‘Reg Cap’) trades and public securitization deals. Both rely heavily on originators and sponsors, not just to supply the assets but also to manage most of the underlying risks, a role which institutional investors should handle more directly.
There is a more effective way for sophisticated investors to access this exciting asset class directly, without relying on third party risk assessments or the availability of lumpy, competitive deals. To retain their ability to generate satisfactory risk-adjusted returns, keep originators in check and truly manage risk, investment managers need to upgrade their technology, secure a more direct and systematic access to origination data and retain the ability to steer asset allocation in real time based on continuous data feeds and advanced predictive analytics.
Combining a powerful data-driven investment platform and strategic partnerships with best-in-class credit originators willing to share origination data (loan-level credit and alternative data) is the way to reinvent granular private credit investment management in the data era.
What is private credit?
Within the alternative credit universe (all but traditional sovereign or corporate debt), private credit refers to non-bank lending where debt is neither issued nor traded on public markets. Private credit is also referred to as ‘direct lending’ or ‘private lending’.
Historically focused on direct lending to mid-sized corporates with little or no access to public markets, private credit now covers a much wider spectrum of borrower types, instruments, risk bands and target yields.
With banks having drastically cut all but the safest lending activities following the 2008 Global Financial Crisis (GFC), the size of the private credit market more than tripled, from US$ 205bn in 2007 to US$ 769bn in 2018.
 McKinsey Global Private Markets Review 2019; Prequin.
Private debt and the wider private markets
Private debt markets are a US$ 769bn subset of the US$ 5.8tn private capital markets which includes private equity and real assets (2018).
What is granular private credit?
Private credit is a meaningful attempt at channeling capital into the real economy, but it has traditionally mostly focused on lending (senior, subordinated or mezzanine debt) to established corporate entities or against sponsored assets. Popular strategies include:
- Direct loans to midsized corporates (secured or unsecured);
- Leveraged Buy Out (LBO) loans to corporates;
- Purchase of banks’ portfolios of Non-Performing Loans (NPL) to corporates;
- Specialty financing (e.g. real estate, aviation, shipping, etc.);
- Special situations financing (opportunistic financing of corporates).
Two broad categories of borrowers in need of financing are not addressed by the above strategies:
- Individual borrowers (consumers, students, homeowners);
- Small businesses.
Financing the real economy really boils down to doing a good job of scoring, pricing and underwriting credit risk in small size to these two categories of borrowers. In this post, we refer to granular private credit to describe the resulting credit asset class.
Commercial banks and credit card companies have traditionally owned the origination process in this cluster of the credit market. Despite being skewed towards the safer end of the credit spectrum (the overbanked ‘prime plus’ and ‘super-prime’ borrowers with an extensive credit history), this business has offered a stable source of profits for incumbent lenders through the cycle (see ‘Zoom: US credit card returns’).
Since the 2008 GFC, banks and credit card companies have been tightening lending criteria further under the joint pressure of regulators and shareholders. A new type of non-bank credit originators, MarketPlace Lenders (MPL), stepped into the picture to offer borrowers more and cheaper options to access credit.
Zoom: the US consumer credit market
With US$ 19tn of outstanding credit (2018), the US consumer credit market is one of the largest and most developed credit markets in the world.
Zoom: US credit card returns
The chart below breaks down historical net returns (in % per annum) across all US commercial banks’ credit card lending activities since 1995. Net returns are approximated as the difference between average interest rates charged and average charge-off rates.
Access to granular private credit: why and how?
The key questions are whether granular private credit presents an attractive investment opportunity for institutional investors, and if so, how best to access that opportunity to maximize risk-adjusted returns and portfolio diversification.
Why granular private credit?
Granular private credit covers a very diverse range of products, borrower types and geographies. The merits of the resulting credit assets must be analyzed in the context of their intrinsic characteristics and their potential to generate attractive risk-adjusted returns.
Risk-adjusted returns. At a very general level, developed credit markets such as the US market show that granular private credit (and especially consumer credit) has consistently ranked among the most profitable business lines for commercial banks, through the credit cycle (see: ‘Zoom: US credit card returns’).
Innovative origination models are transforming the origination process and expanding the credit universe to underserved credit-worthy borrowers, hence creating an exciting source of alpha for sophisticated investors.
Diversity. Granular private credit offers desirable diversification for sophisticated investors. This comes through several key features which distinguish it from the broader private credit asset class, namely:
- High granularity. Individual exposure amounts from a few thousands to a few hundreds of thousands US$;
- All duration profiles. From weeks (invoice financing) to 20+ years (mortgages), but generally at the lower end of the duration spectrum;
- All security options. Secured or unsecured exposures;
- All credit risks. All levels of credit risk (vanilla or structured);
- Global. Granular private credit funds the real economy, globally, exploiting local market dynamics;
- Varied models. Consumer, students, mortgages, specialty finance, small businesses, etc.
Diversification. Low correlation with publicly traded markets, due to its private nature.
Data. Granular means large volumes of credit and alternative data. Private markets are less subject to arbitrage and therefore lend themselves well to machine learning techniques when it comes to forecasting performance.
How to assess the asset class?
Today, there are 2 dominant channels for institutional investors to access this asset class in size:
‘Reg Cap’ trades. An institutional investor (typically an asset manager, a pension fund or an insurance company) negotiates the terms of a private risk-sharing agreement with an originator (usually a bank) keen to reduce its economic exposure and regulatory capital requirement on a specific credit book. The underlying portfolio can be static or replenished over time under a set of qualitative and quantitative constraints.
This way of accessing risk is heavily reliant on the originators’ credit risk assessment and, ultimately, on the investor’s implicit trust in their ability to manage that risk. Mandatory risk retention rules (‘skin in the game’) ensure an alignment of interest between the originator and the investor.
Securitization markets. By far the largest and most transparent way of accessing granular private credit (US$ 164bn originated globally in 2018, across auto loans/leases, credit cards, personal loans and student loans). An originator and an arranger (typically an investment bank) package homogeneous cohorts of loans into tranched securities with separate risk and return profiles (senior, subordinated, mezzanine).
Contrary to private Reg Cap trades, securitization transactions are public. They offer the advantage of larger deployable sizes, standardization, public ratings and reasonable secondary market liquidity. Securitizations have become a well-established funding avenue for granular private credit originators. This also means that a wide variety of homogeneous credit asset pools and risk/return profiles are available through that channel.
Global securitization market
The global credit securitization market supplied US$ 1.04tn of credit assets to institutional investors in 2018. It is a well-established access route through which asset managers and other institutional investors finance the real economy.
Public securitization markets offer the advantage of large deployment sizes, public ratings and secondary market trading, all valued fixtures of institutional investment frameworks.
But securitizations fall short of being an ideal channel of investment into the real economy for institutional investors. This, for a few reasons (most of which also apply to Reg Cap trades):
- Lumpy. Transactions require the pooling of large numbers of granular assets over time, and the structuring of complex contractual structures. As a result, they are infrequent and sought after.
- Rigid. Standardization of risk/return tranches results in a relatively rigid investment format, leaving no space for institutional investors to build bespoke strategies. In particular, the investors would have exposure to a full slice of the platform’s origination, which is sub-optimal in most cases.
- Single originator. A securitization is typically sponsored by a unique credit originator. For an institutional investor to allocate capital to multiple originators, it must participate in multiple securitization deals, as and when these become available.
- Tight yields. Institutions line up to buy securitization tranches due to the attraction of the underlying asset class. The constrained access to those deals puts a structural downward pressure on expected investor yields. Also, costs are significant, due to the complexity of the transactions and the numerous parties involved.
- Risk control. This is probably the most problematic aspect of accessing granular private credit through the securitization market. It does not enable institutional investors to monitor origination risk in a satisfactory manner. Most metrics are provided by rating agencies, at an aggregate level, on a backward-looking basis, and are simplistic compared to the richness of the data available. This is insufficient for institutional investors to assess the overall quality of the originator, leading them to rely entirely on rating agencies’ assessments, simplistic metrics and secondary market price action when allocating capital to the next securitization deal. These transactions are also much more sensitive to markets’ volatility and sentiment.
After the 2008 GFC, a new kind of credit originators, MarketPlace Lending (MPL) platforms, offered a new credit origination and distribution model to institutional investors, to match borrowers’ needs and available capital.
While their business model has been intensely debated (online customer acquisition has proven to be more expensive than initially anticipated), MPL lending platforms have brought a new value proposition to investors by offering to share extensive loan-level data and allow sophisticated investors to form an independent assessment of the quality of their credit origination, hence mitigating the structural misalignment of interests between originator and risk taker at the heart of the 2008 ‘subprime crisis’.
Vast quantities of credit and alternative data are now being produced and made available to incumbent and challenger lenders. Exponential growth in computer power means that powerful machine learning techniques can now be applied to the high dimensional credit scoring problem with a view to drastically expand access to credit in the real economy.
For credit originators, this environment presents a unique opportunity to reach a much larger universe of borrowers with tailored credit offerings at the right price for the risk. This business opportunity must comply with strict regulatory guidelines to ensure credit is originated without introducing undesirable biases (e.g. gender, race, etc.) in the underwriting decision.
This trend, initiated by MPL platforms a decade ago, has now gathered momentum around the globe. Today, granular credit to individual borrowers is being originated in large sizes through online technology platforms (eCommerce, social networks, etc.) and their affiliated financing companies.
Technologically more agile, closer to consumers and small businesses, they have become a major threat to incumbent bank lenders and credit card companies increasingly faced with the risk of becoming what Citigroup Chief Executive Michael Corbat called a ‘dumb utility’.
Granular private credit investor 2.0
The necessary data-driven origination infrastructure now exists on a large enough scale for institutional investors to start paying attention to granular private credit as an exciting opportunity to deploy sizeable capital without being constrained by the traditional channels (Reg Cap trades and securitization deals).
By striking strategic partnerships with best-in-class granular credit originators (e.g. eCommerce platforms, communication platforms, consumer product conglomerates, MPL platforms, etc.), institutional investors can build a powerful private credit sourcing and risk management machine.
The future of investing in this emerging asset class lies in the construction of a data-driven asset allocation machine, plugged directly into the origination data source to detect weak signals of deterioration and investment opportunities early, and redirect regular reinvestments in real time.
The time is right for visionary institutional investors to start putting the right technological and strategic barriers to entry in place to secure a privileged access to the fast-expanding universe of granular private credit.