The asset class providing a formidable wall of opportunity for investors

For anyone who has been in the investing game for a while, you would know that things have changed dramatically over the past 20 years.

As Chris Paton, CIO at La Trobe Financial, puts it, “Once upon a time, the world of investing was quite simple”.

He points out that it used to be simply cash, bonds, and equities – “and the equities were probably a carefully selected portfolio of a few quality stocks”.

Times change, however, and for the first time recently, “the amount of passively managed assets on US stock exchanges now equals the number of actively managed assets. And it’s continuing to grow”.

“In short, people aren’t picking stocks, they’re picking sectors”, says Paton.

At the same time that investors have changed their approach, Paton adds that fewer companies are tapping stock exchanges to raise capital. Rather, the big growth in market capitalisation has been in private markets.

The data shows that private capital markets are increasing significantly in size, a global trend that creates significant opportunities, according to Paton. This is why La Trobe Financial has recently partnered with Morgan Stanley to launch the La Trobe Private Credit Fund.

“With this critical mass, comes opportunity for retail investors to now participate in private markets, which until now, have largely been the domain of the institutional, and to a lesser degree wholesale investors.

And it is providing a formidable wall of opportunity for investors to consider”.

In the following, Paton explains the growth of private credit, the current state of the space, and the La Trobe Financial approach to the opportunity set.

The growth of private credit

Private credit has grown exponentially, and, according to Paton, a range of big generational investment trends are at play that will continue to drive the market's growth and performance.

He sees these trends through what he calls the four D's.

• Digitalisation will see over $1 trillion in investment over the next 10 years to enhance data storage, processing and transmission infrastructure.
• Decarbonisation will necessitate $150 trillion in investment over the next 30 years to support decarbonisation of global energy systems.
• Deglobalisation, as countries and companies onshore critical industries, will drive $1 trillion of investment over the next 10 years.
• And de-banking – arising from the de-risking of our interconnected, global financial plumbing since the GFC, this means there is a wonderful opportunity for investors to participate in these great themes.

Paton believes that the fundamentals of these growth areas, and the assets they will generate, align very closely with the needs of investors.

“They are long-term trends. They will not, likely, become assets with wild price fluctuations. And they will generate income”.

He adds that the growth in quality private capital on offer won’t slow down any time soon, “which positions alternative investments such as private credit with a strong tailwind.”

The current environment

When an area of the market grows quickly, it’s not always a smooth ride, but Paton points out that the market share between bank and non-bank lenders in the US has been settled for around a decade. From an asset origination perspective, non-bank lenders overtook banks in origination of total private credit on an annual basis since 1999, and this trend accelerated post GFC.

“It is no fleeting trend”, says Paton

“But off a low base, critical mass takes time. Slowly but surely, the total quantum of private credit in the market rose. The total market was c$1 trillion in 2020, but now it’s pushing through $2 trillion and beyond”.

As for the impact of interest rate changes—the topic of the moment—Paton points to an index dating back to 2005, “in which directly written loans to US middle market companies have provided an average total return of about 9.4%pa.”

He adds that it is an asset class where managers can extract value and return for investors, if done right, whilst the longevity of the index means it covers a range of interest rate settings.

Paton further explains that these are term assets for investors. “US asset allocators are looking ahead to a strong decade for private credit and allocation volumes”, adding that “the views of the major US asset forecasters over the coming 10 years note private credit as a clear out-performer, with expected returns disproportionately above other asset classes relative to the expected volatility”.

“So, at its simplest, private credit is looking to higher forecasted returns for lower forecasted risk in a moment where the cost of credit is now being priced appropriately.

“That’s a compelling mix for any asset allocator”.

The La Trobe Financial approach

It has been argued that US private markets are under-regulated and carry risk. Before discussing the opportunities that La Trobe Financial pursues, I quizzed Paton about how La Trobe Financial navigates those risks.

He explains that success in any sector starts with getting the fundamentals right, and over La Trobe’s seven decade history, which includes managing Australian real estate private credit, there are three non-negotiables: the right assets, the right structure, and the right manager.

The La Trobe US Private Credit fund invests in a diversified portfolio comprised primarily of directly originated, senior secured first-lien loans provided to companies in the US middle market.

Paton explains that these are large companies (average EBITDA of US$199m), “operating in very deep and diversified industries within the US middle market”

They must be companies that demonstrate strong and stable free-cash flows, which are led by strong management teams in businesses with leading market positions and strong barriers to entry.

“We deliberately avoid lending to companies and sectors that are cyclical in nature. This is important, as we seek to construct a portfolio which delivers performance for investors across the economic and market cycle”, says Paton.

How La Trobe Financial invests

With those specific requirements for context, Paton shares that Morgan Stanley – La Trobe Financial's product partner for this strategy – is highly selective in the loans they approve for the investment portfolio, “rejecting 95% of the 1,000+ loans they originate each year”, says Paton.

“But it’s more than that”, says Paton. “It is rejecting applications to borrowers with less than impeccable management and cash flows. It is retaining an LVR below 50%. It is avoiding exposures to opportunistic credit or distressed applicants”. Paton points out that whilst these may increase yields, they can also disproportionately increase volatility.

“So we simply reject them outright, and focus on a narrow, pure-play portfolio of high quality assets”, says Paton.

In addition to being highly selective, Paton notes that the companies they are lending to are owned by some of the largest private equity firms in the world. “These are private equity firms with deep experience in owning and managing companies in these specific sectors, that have the capacity to assist a company during periods of market stress, overlaid by their own fiduciary obligations they owe to their investors”, says Paton.

The La Trobe Financial strategy is to select assets from the US middle market. As it stands, the US middle market is already the world’s third-largest economy and forms the backbone of the American economy. According to Paton, it will be buttressed by the billions of dollars in public expenditure pledged through the Inflation Reduction Act and the support of both major political parties to re-shore manufacturing and jobs to America.

“For managers and indeed investors, this provides a broad and deep market with tailwinds to select assets to build portfolios with the quality, and risk-return dynamics to suit a whole range of possibilities”.

“The portfolio is, by its nature, conservative and comprised of loans which are primarily first lien, with an average loan-to-value ratio of 42%. This means our borrowers have to pay us first, and to the extent there is any non-performance, we get capital returned first too”.

The outlook ahead

According to Paton, there is little doubt that the growth of private market investment is set to continue this year, next year, and well into the future. 

“Quality companies are tapping private markets for capital. Investors are increasingly looking to private investments to secure low volatility income for their portfolios”.

According to Macquarie, individual investors globally are currently allocating 5% of their wealth to alternatives as at 2023, but AUM is forecast to grow at 9.3% per year through this decade.[1]

“Private credit is well poised to be a big part of this growth”.

La Trobe Financial is trusted to manage investments for over 100,000 investors globally. They are committed to protecting your wealth and delivering market-leading returns across the cycle. Find out more here.