Canada's Private Credit Market Under Scrutiny Amidst Growing Concerns

Canadian investors and banks have an estimated $500-billion of exposure to private credit lending, mostly directed at the United States underwritten by non-bank institutions. The Bank of Canada has raised concerns about this market, but experts say painting the entire asset class with a single brush would obscure the differences between strategies working through this cycle in different ways.

In the US, pressure has been concentrated among large asset managers lending to private-equity-owned businesses, particularly in the software industry. Alternative lenders routinely write cheques between $20-million and $650-million to these borrowers, replacing traditional broadly syndicated bank loans. When one of those large loans experiences trouble, the impact on a concentrated portfolio is meaningful.

In Canada, several real estate credit funds have faced liquidity shortfalls driven by a mismatch between the term of their underlying investments, typically five years or longer, and the frequency of investor redemption rights, which have been offered on a monthly or quarterly basis. When investors requested their capital back, the funds could not liquidate their positions fast enough to meet those requests.

Experts say that while both problems are real and worth watching, they are specific to a subset of the private credit market, not the whole of it. According to the Cliffwater Direct Lending Index, which tracks the broader direct lending market, the asset class has generated positive returns in 19 of the last 20 years, including through the pandemic and the recent interest rate cycle.

Manager selection and due diligence are the difference between capturing the value proposition of uncorrelated, attractive yield and being caught in the funds that make headlines. Strategies focused on direct loans to small- and medium-sized businesses share a set of structural features that put them in a different risk category from the strategies drawing scrutiny.

Canadian investors evaluating a private credit allocation should look for diversification across borrowers and industries, modest use of leverage, an investment term that matches the term of the underlying investments, and an investment thesis that is easy to understand. They should be cautious about concentrated portfolios, strategies focused on a single industry or a single geography, term mismatches between the fund and its investments, and fund managers who get paid fees by the borrowers whose loans they are underwriting.