Inflation, Private Credit

Does High Inflation Have You Confused About Where To Invest?

May 23, 2022
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Inflation is sending investors across the public and private markets mixed signals, leaving them searching for direction on what asset classes or strategies might prove to be a safe harbor. One such strategy is private credit. Why? Historic trends have shown that high inflation motivates the Fed to raise rates, which is good for floating rate yields, (though stressful on interest coverage ratios). And while no rising rate environment looks the same, we believe private credit investors will be rewarded in this market, and that the asset class is poised to deliver the stability and performance it has historically offered.   

But before we demonstrate that, let us address some of the investor fears being triggered by inflation. For starters, input costs are rising. The consumer-price index rose by 8.5% in March from the same month a year earlier. The gasoline index rose 48% over the last year and on the labor front, business and government employers spent 4.5% more on worker costs in the first quarter compared with the same period a year earlier. And let’s not forget the topic du jour - supply chains. The average composite index of the World Container Index year-to-date is $9,116 per 40 ft container, a whopping $5,908 higher than the five-year average of $3,208 per 40 ft container, so shipping costs are up significantly.  

At the policy level, signs point to continued rate hikes. In early May, the Fed raised its benchmark interest rate by half a percentage point. Inflation fears have prompted expectations of continued half-point interest rate hikes at each of the next three scheduled policy meetings and there is speculation the Fed could raise their benchmark rate by as much as 75 basis points in June, marking the first 75-basis-point increase since 1994. Rising input costs and rising rates have investors concerned for two basic reasons. First, a rising cost structure puts pressure on EBITDA and margins, which creates the potential for a deterioration in credit quality, particularly for highly leveraged companies. Second, persistent rate hikes by the Fed could slow growth and push the economy into a recession.  

What are investors to do? The answer is simpler than you might think. Focus manager selection on general partners with scale, market access and credit discipline. It’s likely those managers are gravitating towards recession-resilient sectors and companies with pricing power, flexible cost structures, conservative capital structures, and strong free cash flow conversion, which are some of the key credit attributes required to safely navigate an inflationary environment. 

Despite these pesky inflation pressures, private credit investors have a lot to be optimistic about. To begin with, Hamilton Lane compared private credit IRR over a 20-year period against the Credit Suisse Leveraged Loan public market equivalent or ‘PME’.  

CHART 1 PRIVATE CREDIT IRR VS. PME

Not only did the asset class have consistently positive performance over that time, but it also outperformed the PME every year and with a very narrow dispersion of returns. It is also worth noting we have been through three recessionary periods during that time. Pretty impressive huh? Wait, it gets better.  

Hamilton Lane also evaluated the worst five-year annualized performance of the strategy going back to 1995. At its worst, private credit demonstrated positive 4.6%, outperforming all other private and public markets strategies across equity, credit, and real assets. Private credit did not lose money; therefore, I’ll pause to let that sink in.

CHART 2 LOWEST 5-YEAR ANNUALIZED PERFORMANCE

For investors with exposure to floating rate credit, which is a healthy proportion of the private credit universe today, yields are likely to improve. On April 1, 3-Month LIBOR broke above typical LIBOR floors of 50-100 basis points and reached approximately 1.16%. The forward 3-month LIBOR curve is forecast to exceed 2% over the next twelve months, which would create a nice IRR boost for investors with floating rate exposure. For those wondering what this means for SOFR, there is some encouraging news there too. This time next year, the SOFR forward curve suggests the benchmark rate will break 3%. Not too shabby.

But, if consistency and yield aren’t your thing, you might want to reconsider as some of the public alternatives are less compelling. The bond market is on course for the biggest loss since 1920. As of April 29, year-to-date returns for High Yield were -7.54%. Over the same period, the leveraged loan market has returned 0.07%. Need we look at public equities? Why not: The NASDAQ is having its worst ever start to a year, at -21.2%. As of April 29, the S&P was down 12.4%, which marks its worst start to the year since 1942. Needless to say, it’s been a rough start to 2022 for most public alternatives.

Whether new to the asset class or an existing investor, the data suggests that private credit has been resilient through periods of volatility and has consistently delivered public benchmark outperformance – a worthy consideration for any portfolio. Based on Hamilton Lane research, a +35-year lookback at performance of private credit showed that credit funds investing during rate hikes outperformed credit funds investing during all other periods.  So, the next time you find yourself confused by mixed market signals, take a moment to remember the benefits of private credit.


ENDNOTES 

STRATEGY DEFINITIONS 

Credit: This strategy focuses on providing debt capital. 

INDEX DEFINITIONS: 

BofAML High Yield Index: The BofAML High Yield index tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.  

Credit Suisse Leveraged Loan Index: The CS Leveraged Loan Index represents tradable, senior-secured, U.S. dollar-denominated non-investment grade loans. 

OTHER 

PME (Public Market Equivalent): Calculated by taking the fund cash flows and investing them in a relevant index. The fund cash flows are pooled such that capital calls are simulated as index share purchases and distributions as index share sales. Contributions are scaled by a factor such that the ending portfolio balance is equal to the private equity net asset value (equal ending exposures for both portfolios). This seeks to prevent shorting of the public market equivalent portfolio. Distributions are not scaled by this factor. The IRR is calculated based on these adjusted cash flows. 

DISCLOSURES 

This presentation has been prepared solely for informational purposes and contains confidential and proprietary information, the disclosure of which could be harmful to Hamilton Lane. Accordingly, the recipients of this presentation are requested to maintain the confidentiality of the information contained herein. This presentation may not be copied or distributed, in whole or in part, without the prior written consent of Hamilton Lane. 

The information contained in this presentation may include forward-looking statements regarding returns, performance, opinions, the fund presented or its portfolio companies, or other events contained herein. Forward-looking statements include a number of risks, uncertainties and other factors beyond our control, or the control of the fund or the portfolio companies, which may result in material differences in actual results, performance or other expectations. The opinions, estimates and analyses reflect our current judgment, which may change in the future. 

All opinions, estimates and forecasts of future performance or other events contained herein are based on information available to Hamilton Lane as of the date of this presentation and are subject to change. Past performance of the investments described herein is not indicative of future results. In addition, nothing contained herein shall be deemed to be a prediction of future performance. The information included in this presentation has not been reviewed or audited by independent public accountants. Certain information included herein has been obtained from sources that Hamilton Lane believes to be reliable, but the accuracy of such information cannot be guaranteed. 

This presentation is not an offer to sell, or a solicitation of any offer to buy, any security or to enter into any agreement with Hamilton Lane or any of its affiliates. Any such offering will be made only at your request. We do not intend that any public offering will be made by us at any time with respect to any potential transaction discussed in this presentation. Any offering or potential transaction will be made pursuant to separate documentation negotiated between us, which will supersede entirely the information contained herein. 

Certain of the performance results included herein do not reflect the deduction of any applicable advisory or management fees, since it is not possible to allocate such fees accurately in a vintage year presentation or in a composite measured at different points in time. A client’s rate of return will be reduced by any applicable advisory or management fees, carried interest and any expenses incurred. Hamilton Lane’s fees are described in Part 2 of our Form ADV, a copy of which is available upon request. 

The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of-funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fund-of-funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12-year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return. 

Hamilton Lane (Germany) GmbH is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (Germany) GmbH is authorised and regulated by the Federal Financial Supervisory Authority (BaFin). In the European Economic Area this communication is directed solely at persons who would be classified as professional investors within the meaning of Directive 2011/61/EU (AIFMD). Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients. 

Hamilton Lane (UK) Limited is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (UK) Limited is authorised and regulated by the Financial Conduct Authority (FCA). In the United Kingdom this communication is directed solely at persons who would be classified as a professional client or eligible counterparty under the FCA Handbook of Rules and Guidance. Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients. 

Hamilton Lane Advisors, L.L.C. is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services by operation of ASIC Class Order 03/1100: U.S. SEC regulated financial service providers. Hamilton Lane Advisors, L.L.C. is regulated by the SEC under U.S. laws, which differ from Australian laws. 

Any tables, graphs or charts relating to past performance included in this presentation are intended only to illustrate the performance of the indices, composites, specific accounts or funds referred to for the historical periods shown. Such tables, graphs and charts are not intended to predict future performance and should not be used as the basis for an investment decision. 

The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice, or investment recommendations. You should consult your accounting, legal, tax or other advisors about the matters discussed herein. 

The calculations contained in this document are made by Hamilton Lane based on information provided by the general partner (e.g. cash flows and valuations), and have not been prepared, reviewed or approved by the general partners. 

As of May 19, 2022

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