Portfolio Diversification:
The Case for
Private Credit

“Banks were once places to hold money and were very careful in lending to finance families as they built a future.” —  Elizabeth Warren

Before her political career, Warren was an influential professor in commercial and bankruptcy law and is well versed in banking practices and economics, even calling for tougher bank regulation before the Great Recession of 2008–2009. In her famous toaster analogy, she noted that the government wouldn’t allow a consumer to buy appliances they deemed unsafe. An alternative way of saying “financial products should be treated similarly.”

While banks are tightening lending practices, making it more expensive for households and businesses to get a loan, this is presumably to protect themselves in the event of a recession.

But credit is a valuable part of the economy, and certain investors are seeing a need to fill the void left behind. Enter private lending—also known as direct lending made through negotiations with a non-bank lender, an alternative investment class that can significantly benefit your portfolio.

Why are banks tightening lending standards?

According to a Federal Reserve Senior Loan Officer Opinion Survey, 51.8% of banks said they had tightened loan standards for large- and medium-sized businesses over the second quarter of 2023. The following October issue reports that 35.6% continued to tighten while 62.7% have remained relatively unchanged. Throughout 2024, three additional surveys have been released, and the vast majority have stayed put, with a few going so far as to be even more discerning when offering loans.

Although recent promising inflation data, interest rate reductions, and more positive news have come forward, banks seem to be more hesitant than the broader market sentiment.

Respondents largely cited economic uncertainty, deterioration in bank liquidity, weakened collateral values, reduced risk tolerance, deposit outflows, flagging credit quality, and legislative changes. All in all, concerned banking institutions are positioning themselves defensively as pressures increase and demand tapers off. Unpaid loans aren't exactly known to generate profit.

Why is credit important for the economy?

For the everyday consumer, loans act as a leg-up to improve their quality of life (within reason), be it through a student loan, picking out a new car for a growing family, or purchasing a home. Whether it be expanding operations and hiring skilled workers, securing more cost-efficient equipment, or acquiring other companies, businesses use credit in a similar capacity.

Whatever the case may be, loans typically serve the liquidity demands of today under the assumption that they’ll lead to a net-positive outcome to offset the interest payments they come with.

It’s important to remember that credit is ultimately a tool and should be used appropriately—a hammer is best suited for a nail, not a screw. After the global financial crisis, central banks aggressively cut interest rates to zero or near zero; if inflation is above the interest rate on the loan (known as negative interest rates), it incentivizes borrowers to spend or invest instead of saving, as money left in a savings account erodes purchasing power. In a nutshell, regulatory bodies may implement negative rates during deflationary periods where cash hoarding hurts overall aggregated demand.

When years of negative interest rates are capped by a global pandemic, countrywide lockdowns, increased government support for consumers, weakened supply chains, and pent-up demand without a release valve, you have the recipe for 2023's economic environment.

Once restrictions were lifted and households were flush with elevated savings, central banks were faced with the difficult task of curbing demand. This wasn’t exactly easy, and after years of the softest monetary policy for quite some time, the pendulum swung back with one of the most aggressive interest rate hike cycles in history. Public markets, like households and businesses, have struggled with these rapid changes.

How can private lending fill the credit void?

A key word above is public markets. As private investment opportunities are typically reserved for institutional investors, alternative securities tend to be more insulated from investor sentiment and exhibit greater price stability during periods of heightened volatility. With the public removed from the equation, alternatives usually have a lower correlation to traditional investments and are used as an effective way to diversify portfolios.

There are several variations of alternative investments, and while we have exposure to several, the focus today is on private lending strategies. Jonathan Gray, president of Blackstone, has gone so far as to declare that this is a “golden moment” for the fast-growing industry earlier this year.

But how is it positioned to excel? With the rare combination of a high-interest rate environment baring down on borrowers alongside traditional lenders pulling back, private lenders can take advantage of these opportunistic market conditions:

• Many private loans have floating rates that adjust according to central bank policy changes, benefiting investors while others nurse losses.

• With reduced credit supply, private lenders can go into contract negotiations with less competition from traditional lenders and offset reduced demand.

• To offer a degree of risk protection, private loans are frequently secured by assets (collateral) near the top of the capital structure.

Where does Bellwether stand?

We’ve been firm believers in alternative investments for longer than the recent attention they’ve received, and with our strategies and fund managers in place, we’re not only ready to take advantage of opportunities as they arise—we already have been. Experts continue to say that individual investors are likely underallocated towards private credit, especially given the asset class’s record-breaking year, surging to approximately $1.5 trillion.

Thankfully, we’ve been invested in this thriving asset class for long enough to know how to make the best of it for our clients. Alternatives have a host of benefits to offer investors, but like all investments, they also exhibit certain features that must be accounted for—a caveat that we’re well accustomed to.

Article updated on September 24th to reflect the most recent data reports from the Board of Governors of the Federal Reserve System to include 2024's survey results.