Wonder what expert investors think of private credit? We ask David Scopelliti, the global head of private credit at Mercer.

One of the notable things for me – was the ability for experienced and resourced private credit asset managers to pivot and play defense and offense at the same time. - David Scopelliti, Global Head of Private Credit, Mercer

David, thank you for joining us for our inaugural installment of Private Capital Call – a monthly Q&A with top thought leaders in private capital.

1. 2020 Review. Let’s start with last year. Were you surprised how fast the recovery was from the lows of March?

Yes and no. The level and speed of monetary stimulus was truly unprecedented – with even high yield bonds on the shopping list – with the benefit of hindsight you can see how liquid markets were propped up. Record issuances of high yield with lower interest burdens and extended maturities surely has helped larger companies who can tap that market. Given the headlines, I think it’s easy to overlook mid-market type companies who did not benefit from direct central bank intervention, in some cases were bypassed by government support. This is where Private Credit comes into play.

The real question, is whether 90 or 95% of activity or profits of pre-Covid levels for businesses is considered a recovery, and how sustainable will that last without further stimulus. Broadly speaking, I would say middle market businesses have regained their footing without the benefit of monetary stimulus and would be served well with a round of fiscal stimulus. We have seen portfolio valuations and underlying company level performance has generally rebounded from lows of last year in line with the broader credit markets.

2. Injections and Projections. It seems private credit, always less correlated to liquid assets, found its own path detached from infections and markets. What else did you find notable?

One of the notable things for me – was the ability for experienced and resourced private credit asset managers to pivot and play defense and offense at the same time. This factor alone I think has been underappreciated. With respect to correlations, our analysis would suggest that private credit continues to be less correlated to its liquid benchmarks – notably high yield and broadly syndicated loans. In fact, we have seen performance outpace those asset classes even through Covid-19 over the last ten plus years. The illiquidity premium coupled with a more fundamental approach to credit has paid off for many investors.

Having said that, we believe the key to being less correlated is tied to a thoughtful approach to diversification across the four main strategies in private credit – direct lending, structured credit, specialty finance and opportunistic credit. As we look at the evolution of the asset class, I can see it doubling in the next 5-7 years fueled by low rates, continued retrenchment of the banks globally and a premium yield relative to other asset classes.

3. Movers and Shakers. Volatility is lower than its highest levels last year, but still higher than pre-COVID. What unseen risks are out there? What will be different about 2021?

Clearly given the shock to the system, it takes time to bring balance back. The latency in supply chains continues – working through this will take more time and capital. Sustained government spending will help a number of sectors, education, pharma & healthcare along with much talked about prospective spending on infrastructure. With low rates, the ROI required to earn excess returns is low, which might help boost reshoring initiatives to mitigate supply chain risks. 

On the consumer front, spending on home-related items, electronics and other items to make the continued work-from-home reality more comfortable has not abated. Anecdotally, my local paint store salesperson commented on the surge in DIY painting projects, which is one data point in the cyclical rebound we are starting to see in the markets. For 2021, accommodative rates and government stimulus will fuel asset prices and drive GDP and the enormous pent-up demand for travel and leisure services will likely provide a boost to the economy in the second half as the vaccine roll out continues.  

4. Asset Selection – David, how are you thinking about portfolio diversity at Mercer? What role does private credit play in your overall strategy, and has that strengthened post-COVID?

The case for diversification has never been stronger – particularly for an asset class where risk is skewed to the downside – like private credit. I am a fan of the “known unknowns” concept and the pandemic is proof of that. With the world economies more connected than any time in history, and the instantaneous information flow, we are building portfolios that have diversification in terms of underlying counter-party exposure, industry and geography. We’re constantly looking to where capital might be scarce, to seek the risk-adjusted returns (of course layering on manager selection which is vital in private markets). We have expanded our investment themes to different strategies like collateralized loan obligations, private credit secondary’s, NAV lending, specialty asset financing and opportunistic “all-weather” strategies where the competitive set may be less competitive. 

Private credit has proved to be a diversifier for our portfolios in the wake of the volatility. Remember, there are more private companies than public companies or high yield issuers, so you are getting exposure to different risk and higher return profiles via private credit. Given how private credit has performed throughout the cycle, we are seeing much more interest in the asset class.

5. Mark-to-Markets – The prospect of higher rates has turned retail fund flows around, with $5 billion in-flows so far. What’s your view of BSL and HY bonds, relative to private capital benefits?

BSL and HY bonds certainly have a place in the asset allocation mix. In fact, we are looking at these asset classes to help increase the funded efficiency ratio in our multi-strategy credit portfolios where a drawdown fund is the primary vehicle for capital deployment. Investors searching for yield in a low yield environment are more likely to take risk that come with BSL and HY bonds. Couple this with an accommodative Fed who effectively issued a put option to these markets, it is no wonder you are seeing these fund flows.

6. Manager Selection – Popularity of the asset class has made private credit more crowded. What distinguishes the best managers? Where is the puck going for the asset class?

This is one of my favorite topics. We saw well over 400 funds last year and sorting out the wheat from the chafe can be difficult. However, I lean on the 5Ps – People, Performance, Product (strategy) Process and Price (terms). Given the dispersion of returns in Private Credit is much tighter than Private Equity, performance in terms of low defaults, cost of leverage and fees really matter.

The growth, evolution and structure of the asset class does index towards larger and more diversified platforms, although there is a place for specialists. This is why you are seeing more M&A in the private credit market – Onex’s acquisition of Falcon is a great example of expanding the platform and providing diversified products to investors. Having said all of this, I do want to touch on what we believe to be one of the most critical issues, which is people and culture, where it is a matter of art and science. When a fund commitment is made, you trust the people who run the firm will exercise sound judgement not only in their investments, but with regards to their people. Whether that is hiring the right talent, developing that team and rewarding them both economically and intellectually – this continues to be a key top diligence focus for us – it is also the hardest part to measure.

Lastly, I would be remiss not to add that ESG is a heavy factor in our manager selection process and can mean the difference when selecting fund managers. We look to see that ESG is more than some document the firm’s lawyer drafted, but emblematic in terms of how management runs the business as well as portfolio construction.

<end> 

Important notices

References to Mercer shall be construed to include Mercer LLC and/or its associated companies.

? 2021 Mercer LLC. All rights reserved.

This content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity without Mercer's prior written permission.

Mercer does not provide tax or legal advice. You should contact your tax advisor, accountant and/or attorney before making any decisions with tax or legal implications.

This does not constitute an offer to purchase or sell any securities. Mercer provides services to institutional clients only. 

The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed.

This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances. Mercer provides recommendations based on the particular client's circumstances, investment objectives and needs. As such, investment results will vary and actual results may differ materially.

Private funds are for sophisticated investors only who are accredited investors or qualified purchasers. Funds of private capital funds are speculative and involve a high degree of risk. Private capital fund managers have total authority over the private capital funds. The use of a single advisor applying similar strategies could mean lack of diversification and, consequentially, higher risk. Funds of private capital funds are not liquid and require investors to commit to funding capital calls over a period of several years; any default on a capital call may result in substantial penalties and/or legal action. An investor could lose all or a substantial amount of his or her investment. There are restrictions on transferring interests in private capital funds. Funds of private capital funds’ fees and expenses may offset private capital funds’ profits. Funds of private capital funds are not required to provide periodic pricing or valuation information to investors. Funds of private capital funds may involve complex tax structures and delays in distributing important tax information. Funds of private capital funds are not subject to the same regulatory requirements as mutual funds. Fund offering may only be made through a Private Placement Memorandum (PPM).

Information contained herein may have been obtained from a range of third party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential, or incidental damages) for any error, omission or inaccuracy in the data supplied by any third party.

Investment management and advisory services for U.S. clients are provided by Mercer Investments LLC (Mercer Investments). Mercer Investments LLC is registered to do business as “Mercer Investment Advisers LLC” in the following states: Arizona, California, Florida, Illinois, Kentucky, New Jersey, North Carolina, Oklahoma, Pennsylvania, Texas, and West Virginia; as “Mercer Investments LLC (Delaware)” in Georgia; as “Mercer Investments LLC of Delaware” in Louisiana; and “Mercer Investments LLC, a limited liability company of Delaware” in Oregon. Mercer Investments LLC is a federally registered investment adviser under the Investment Advisers Act of 1940, as amended. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Mercer Investments’ Form ADV Part 2A & 2B can be obtained by written request directed to: Compliance Department, Mercer Investments, 99 High Street, Boston, MA 02110.