Investing in private credit: Bond-like stability, equity-like returns

March 1, 2021

Wesley Blight

Fixed income investments are an important part of a well-diversified portfolio. The asset class generally provides price stability and predictable income at predetermined intervals to help you achieve your financial goals. It is this stability that can soften the volatility of equity investments in a balanced portfolio.

However, with interest rates at historic lows (and expected to stay low for some time) as central banks around the world continue to support the global economy through the pandemic, traditional fixed income investors will be challenged with lower expected returns.

This leaves fixed income investors with two options:

Continue with traditional fixed income investments (like Government of Canada bonds and GICs) and accept the lower return. This cautious approach might not provide the returns required to meet your goals.
Shift to investments that typically generate higher returns (like publicly traded stocks) and accept the added volatility and increased risk profile.

Enter option three: Private credit

What is private credit? In a nutshell, private credit covers a broad range of non-traditional investments that:

Are specific lending agreements between a borrower, often a company, and a lender, the investor,
Do not trade on a public market,
And typically do not originate from a bank.

Outside of characteristics two and three, private credit is similar to traditional debt-based fixed income investments like bonds. What makes private credit an attractive investment opportunity is that it offers higher potential returns, investment risk that is lower than stocks and comparable to traditional fixed income and unique diversification benefits.

Private credit can generate higher potential returns than what is possible with traditional fixed income because private credit borrowers are willing to accept a higher cost of capital to fund its operations. These borrowers, especially small-to-medium-sized companies, do not have access to more favourable terms in public markets so they are willing to pay higher interest to borrow. Part of this premium can be attributed to the illiquid nature of these loans – the lender is being compensated for not being able to readily trade the loan like a traditional bond.

How is private credit able to maintain lower investment risk that is comparable to traditional fixed income? By using carefully crafted loan agreements. As the loan terms are determined by the borrower and the lender directly, the lender can negotiate where the loan will rank in the borrowing company’s capital structure as well as protections via covenants that can restrict the use of the funds, restrict the payment of dividends and even seek board observation seats to better monitor the borrowing company (and the performance of the loan!). Additionally, interest payments for private credit loans are typically calculated using a floating reference rate which limits the loans’ exposure to interest rate risk.

Historically, the asset class has performed differently from publicly traded stocks and bonds. Performance is typically attributed to different factors and to a different magnitude. This low correlation to traditional investments makes private credit a powerful portfolio diversification tool.

While the asset class is not new, it is increased in both available opportunities and popularity with institutional investors. The reduction in capital being supplied by traditional lenders (updated banking regulations in the U.S. and Europe made it more expensive and difficult for banks to lend to private businesses), the ongoing demand for capital from private business (there are nearly 200,000 middle market companies in the U.S. alone¹) and institutional investors looking for better returns in a low interest rate environment has really driven the availability and popularity of the asset class.

Introducing the MD Platinum^TM Global Private Credit Pool

Starting on March 1, the subscription period of the MD Platinum Global Private Credit Pool will open, and MD Private Investment Counsel clients will gain access to this exciting asset class that is generally reserved for larger institutional investors.

The conservative strategy of the MD Platinum Global Private Credit Pool is about the preservation of wealth – it seeks elevated fixed income returns (we are targeting between 6.5% and 8% net returns) and it focuses on capital preservation through prudent risk management. In return, the Pool requires investors to remain invested for a longer period – 10 years in this case – so that it can have the opportunity to fully realize the value of the private credit loans.

Most of the investments that will be held within the Pool are first-lien, senior secured loans. In addition to being ranked highest in the borrowing company’s capital structure and having negotiated structural protections (the covenants we spoke about earlier), these senior loans are less exposed to the business cycle. The Pool is looking to maximize control over the loans – greater influence over the structuring of the loan agreements and management of the loans – because we want to maximize recovery and minimize losses should the Pool encounter defaults.

Within the Pool, we want to ensure that we have a diverse selection of loans with many sources of origination. We expect the Pool to hold more than 200 loans that span different geographies and industries. We're targeting 60% of the loans to be made to companies in the U.S. and 40% to be made to companies in Europe. We’re also seeking to have less than 30% exposure to any single sector.

Similar to the MD Platinum Global Private Equity Pool and the MD Platinum Global Real Estate Pool, our private credit offering will avoid cyclical businesses and have limited exposure to energy companies. Ultimately, the MD Platinum Global Private Credit Pool is looking for loans to resilient companies with understandable business models, sustainable free cash flow, proven management teams, recurring revenue, defensible market niches and diverse customer as well as supplier bases.

As part of the Pool’s conservative strategy, the use of leverage will be limited. While more leverage could potentially augment returns, it also increases downside risk. We do not believe that extreme use of leverage is necessary to achieve our return target, so we’ve capped leverage at 1X. What this means is that the Pool will have the ability to lend twice as much as the cash that is invested in the Pool. We believe this is sufficient to provide meaningful exposure to private credit and to enhance returns.

Find out if private credit makes sense for you

Now is the time to determine if adding private credit to your portfolio will better help you achieve your financial goals. From an asset class perspective, lending conditions are tighter – offering better opportunities with stronger terms for investors. From the perspective of the MD Platinum Global Private Credit Pool, it is a limited time opportunity – the subscription period runs from March 1, 2021-to-August 31, 2021.

The MD Platinum Global Private Credit Pool can serve many purposes. It can be used as a portfolio diversification tool, providing access to private credit and returns generally unavailable to individual investors. It could be used as an opportunity to lower overall portfolio risk without reducing expected long-term returns. It could serve as a partial substitute for traditional fixed income investments for those prioritizing higher returns in a low interest rate environment.

With a US$25,000 minimum investment requirement, it’s very important to determine how the MD Platinum Global Private Credit Pool will fit in your portfolio. For example, what allocation is appropriate to provide meaningful exposure to private credit while maintaining a well-diversified portfolio and ensuring the rest of your portfolio can provide adequate liquidity for more immediate needs.

To determine how private credit and the MD Platinum Global Private Credit Pool can work for you, please contact an MD Advisor*.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

¹ 4Q 2020 Middle Market Indicator. National Center for the Middle Market. https://www.middlemarketcenter.org/Media/Documents/MiddleMarketIndicators/2020-Q4/FullReport/NCMM_MMI_Q4_2020.pdf

The information contained herein provides key information about the respective MD Platinum™ funds and is not intended to be taken by and should not be taken by any individual recipient as investment advice, a recommendation to buy, hold or sell any security, or an offer to sell or a solicitation of offers to purchase any security. The Platinum funds described in this document are subject to additional terms and conditions set out in the Platinum funds’ operative agreements and regulatory suitability requirements as considered by the MD Private Investment Counsel Portfolio Manager. The Platinum funds’ operative agreements will also set out additional information about the investment objective, terms and conditions of such fund, tax information and risk disclosure that are a material terms regarding a fund. Any investment in a fund would be speculative and would involve significant risks. The information and strategies presented here are not suitable for U.S. persons (citizens, residents or green card holders) or non-residents of Canada, or for situations involving such individuals. Employees of the MD Group of Companies are not authorized to make any determination of a client’s U.S. status or tax filing obligations, whether foreign or domestic. The fund is intended for individuals that are discretionary managed account clients of MD Private Investment Counsel, an operating division of MD Financial Management Inc., which provides investment counselling services.

Management fees and expenses associated with investing in MD Platinum™ private funds may be higher than fees and expenses in public security funds. No guarantee or representation is made that any MD Platinum™ private investment fund offered will achieve its investment objective.

There are additional risks associated with investing in private investments that are not applicable to typical investments in the public securities markets. These risks include, but are not limited to, the following: private investment funds are speculative and involve a high degree of risk; an investor could lose all or a substantial amount of his or her investment; interests in private credit investments are illiquid and there is no secondary market, nor is one expected to develop, for interests in such investments; there are significant restrictions on transferring private credit investments; private credit investments experience volatile performance; private credit funds are often concentrated and lack diversification and regulatory oversight. Leverage may be employed, which can make investment performance volatile. Private credit investments are sensitive to factors such as changes in equity values of borrowing companies, interest rates, cash flow of underlying borrowing companies, loan documentation and structuring, and a manager’s skill as well as credit risks and tax and regulatory requirements.

MD Platinum™ is a trademark of The Bank of Nova Scotia, used under licence. MD Financial Management provides financial products and services, the MD Family of Funds and investment counselling services through the MD Group of Companies. For a detailed list of these companies, visit md.ca.

Certain information contained herein constitutes “forward-looking statements.” Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. As a result, the Recipient should not rely on such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements. The information contained in this document is not intended to offer foreign or domestic taxation, legal, accounting or similar professional advice, nor is it intended to replace the advice of independent tax, accounting or legal professionals. Incorporation guidance is limited to asset allocation and integrating corporate entities into financial plans and wealth strategies. Any tax-related information is applicable to Canadian residents only and is in accordance with current Canadian tax law including judicial and administrative interpretation.

For further information on the structure, features and risks of the MD Platinum™ Global Private Credit Pool Limited Partnership, please consult the MD Platinum™ Global Private Credit Pool Limited Partnership Term Sheet and your MD Private Investment Counsel Portfolio Manager.