The case for private credit

This op-ed originally appeared in Funds Europe.

At a time when cracks are appearing in mainstream private credit, emerging market private credit strategies can offer valuable diversification opportunities, resilience and impact, against a backdrop of higher economic growth and less saturated investment markets.

While emerging markets have traditionally been perceived as higher risk than their developed equivalents, we would argue that they provide a wealth of high-growth opportunity for private credit investors, for lending that combines impact with attractive returns at lower risk than meets the eye. The fundamental issue is that investors tend to use sovereign credit ratings as ceilings on emerging market private-sector credit. This can overstate the credit risk represented by high-quality borrowers.

Perception among many investors is that emerging market issuers will lead to losses of between four and six percent over five years (based on large rating agency default & recovery rates). Instead, the World Bank’s Global Emerging Markets (GEMS) Database – which tracks over 15,000 loans to private companies in developing economies over 30 years – demonstrated an actual average loss rate of 1.62% over the same period – at least two and half times better than expected.

Even this rate is substantially higher than that which a skilled investment manager can achieve, Over 20 years, we at Finance in Motion have lent more than €10bn of private credit to borrowers in 47 emerging markets, across the full gamut of debt instruments and strategies, with a comparable loss rate of less than 0.2%. That’s 20 times lower risk than predicted by the rating agencies. But that perception of outsized risks is deeply embedded.

A lower-risk class of borrower

In both developed and emerging markets, private credit fills a gap in the financial system. But the difference between the two is that private credit borrowers in emerging markets tend to be much lower-risk prospects within their national contexts than their peers in developed countries.

One of the key opportunities we see in the emerging markets in which we operate is in lending to financial institutions. These might be local banks, leasing companies or microfinance institutions. These institutions tend to lack access to the local capital markets that developed-world financial institutions use to fund themselves. Instead, most of their funding comes from their (often narrow) deposit bases.

The second is that their business development capacity can be more limited. Rather than building new revenue lines from lending to local underbanked SMEs or infrastructure, with debt underwritten by projected future cashflows, they can be more comfortable lending to existing corporate clients, secured against hard collateral, usually real estate. These more complex underwriting requirements often mean important drivers of growth and investment remain under-banked.

There is also opportunity in lending directly to corporates in emerging markets – again, addressing the lack of liquid corporate bond markets in these economies. They are very different users of private credit to those found in developed economies. Rather than M&A targets seeking leverage ahead of a buy-out or riskier growth lending, we focus on established real-economy companies looking for debt to invest in their future growth.

There is a third opportunity in clean energy infrastructure. Emerging economies are structurally short energy capacity or are catching up on the clean energy transition. The declining costs of renewable energy and battery storage technology are creating enormous opportunity to build out energy infrastructure in emerging markets. Structured as non-recourse lending to special purpose vehicles and secured against future cash flows, this debt can offer attractive risk-return characteristics and is often highly limited in domestic markets.

The blended finance boost

By identifying attractive credits in overlooked markets, investors can generate similar risk-adjusted returns in emerging markets than can be found in developed markets. But we recognise that there is an opportunity cost: why look to unfamiliar jurisdictions when that capital can earn similar returns in more familiar domestic markets?

As well as an internal fiduciary challenge for investors, track records are valuable, but ratings still dominate. To address this disincentive to invest offshore, blended finance funds offer catalytic capital to address risk perceptions, improve effective returns and thus help attract institutional investors into emerging markets. By blending concessional finance into the capital stack or at the transaction level, investment managers can offer enhanced credit ratings and first-loss guarantees to protect private sector institutional capital, improving the risk-return calculation.

Boots on the ground

Certainly, it is difficult – if not impossible – to successfully deploy private credit to emerging markets from a desk in London or New York. Limited public debt markets mean that, by definition, information is hard to come by. Market dynamics can be unpredictable. Regulatory regimes can be idiosyncratic.

But investment managers with a strong local presence in emerging markets are well positioned to spot opportunities and deliver for their investors. At a time when traditional private credit might be starting to hit its limits in developed economies, emerging markets strategies open new doors and present valuable new opportunities.