Viewpoints

A Multi‑sector Approach to Semiliquid Private Credit

The ability to pivot across the whole spectrum of private credit enables investors to seek meaningful diversification, portfolio resilience, and a wider opportunity set to source attractive and consistent yield.

Amid rising inflation and geopolitical uncertainty, many high net worth individuals (HNWIs) are seeking investment opportunities to help mitigate downside risk and hedge against rising interest rates. In our view, high quality, multi-sector private credit strategies could fit the bill. They have the potential to offer both – in addition to periodic liquidity, consistent income distributions, and an attractive return profile.

“Semiliquid” funds may hold special appeal for HNWIs. These vehicles typically invest primarily in private assets and are structured to offer periodic – often quarterly – redemptions. They can offer investors greater liquidity than many traditional, closed-end private market funds, yet can provide higher distribution yields and return potential than traditional mutual funds. By giving up some liquidity, HNWIs are able to access investments that are uniquely sourced, enjoy relatively high barriers to entry, and can offer attractive yields and upside potential in exchange for illiquidity and complexity risk.

As an additional potential benefit, semiliquid funds have typically demonstrated less volatility than publicly traded assets during periods of market stress. This offers the potential of low levels of correlation with public market investments and may add diversification benefits to investor portfolios.

Private credit may offer attractive yield and a potential hedge from rising rates

We believe the opportunity set in private credit is particularly rich and can help provide opportunity for enhanced yield and return expectations without necessarily compromising credit quality.

In addition to the potential for an attractive yield pick-up over similar-quality public market fixed income, private credit may be more resilient in today’s rising rate environment. This is because private credit assets are often floating-rate instruments whose interest payments reset periodically as base rates increase. Short maturities, which are typical across the private credit landscape, may allow investors to benefit by reinvesting capital with terms aligned with current market conditions. These characteristics can help HNWIs mitigate the impact of potentially sustained high inflation and further rate increases while providing an efficient way to potentially earn an attractive and consistent distribution yield.

Why we favour multi-sector over single sector over the long run

Numerous types of private credit assets can provide attractive contractual income with resilient risk profiles, most notably in areas where traditional bank lenders face constraints and many nonbank lenders face barriers to entry. Examples include private corporate loans, residential mortgage credit, commercial real estate debt, and other forms of asset-backed lending like specialty finance.

The variety of private income-producing credit assets provides scope to build meaningful economic diversification within a multi-sector credit strategy. Different sectors typically have varying sensitivities to personal incomes, profit margins, lease rates, and collateral values. For example, rising wages can improve debt service coverage for consumers while eroding corporate profit margins. Inflation may support real estate collateral values while rising mortgage costs temper demand and reduce affordability.

Given the significant capital raised in private credit over the last few years, particularly in middle market corporate lending where there are few barriers to entry, we believe it is more important than ever to retain investment discipline and take a more dynamic approach. Raising too much capital or having too narrow a mandate may increase the temptation to stretch underwriting assumptions to win deals and maintain borrower relationships. Broad, flexible multi-sector credit strategies can help managers maintain investment discipline by allowing a pivot to less crowded and more resilient sectors. A truly resilient approach requires selectivity, with a sharp focus on robust cash flow underwriting, strong asset backing, structural seniority, and tightly negotiated covenants.

Three characteristics to look for when investing in semiliquid private credit strategies

When considering a semiliquid strategy to invest in, we suggest taking the following three attributes into account:

1) Multiple sources of yield and return

The range of semiliquid strategies has grown significantly in recent years, yet most remain focused on a single sector – corporate lending. Within private credit, the opportunity set is much broader than the many middle market direct lending strategies suggest. A strategy that can invest flexibly across the broad spectrum of private credit allows an asset manager to invest only in what they see as the best opportunities, while potentially enhancing portfolio diversification.

2) A well-structured “liquidity bucket”

Because these strategies invest in private and typically less liquid assets, it’s important to ensure that the liquidity being offered is reliable and focused in higher quality assets. Typically, managers achieve more frequent liquidity by allocating part of the asset mix to more liquid traded securities or a “liquidity sleeve.” But investors should ask, Is this allocation sufficient to give investors liquidity when they need it most? Do the securities offer an attractive yield without introducing additional volatility? We believe a well-designed liquidity structure is just as important as the sourcing of attractive private investments.

3) Sustainable distribution yields

Lofty distribution yields that are greater than or similar to total return targets or yields-to-maturity can be a red flag. With the addition of fees, a default or two in a portfolio could potentially lead investors down a path of net asset value (NAV) decline. More conservative distribution yields can potentially withstand periods of stress should they emerge and set investors up for more stable and stronger long-term gains.

The global macro environment remains anything but normal, and investors will have to navigate a volatile and challenging path over the next few years. As we enter an environment of higher interest rates, uneven growth and uncertain inflation, traditional capital market returns are likely to become lower and more volatile.

We believe a dynamic, multi-sector approach to semiliquid private credit that is designed to be resilient and seeks to provide consistent income could play an important structural role in many investors’ portfolios.

For details on our outlook for the global economy and the implications for investors, read our latest Cyclical Outlook: “Prevailing Under Pressure.”

The Author

Patrick Beuret

Executive Vice President, Head of PIMCO Switzerland

Kyle McCarthy

Alternative Credit Strategist

David Ellison

Vice President, Account Manager

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Disclosures

Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price. All investments contain risk and may lose value. Diversification does not ensure against loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.