Education

Understanding Alternative Credit Opportunities

What you will learn

The basics of alternative credit
What direct lending is and the potential benefits and risks
The concept of the J Curve

Alternative credit is illiquid financing provided to borrowers of capital who cannot access public or require non-standard, customized loan terms. Bottom of Form With increasing regulation around the practices of traditional lenders, alternative credit has emerged to play a more pivotal role in helping institutional and high-net-worth investors reduce reliance on the equity risk premium and drive investment returns. Accessed predominately via limited partnerships (LPs) with required “lock-up” periods, the alternative credit market has seen significant growth in recent years and presents investors with an opportunity to earn attractive returns.

What drives demand for alternative credit?

Since the global financial crisis, regulators and governments around the world have increased their scrutiny of the lending habits of traditional banks. While these changes have created a more robust and resilient banking system, traditional lenders no longer take the same types of risks and have been forced to retreat from certain lending practices.

This change has created an interesting opportunity for investors and has, in part, driven the emergence of alternative credit. Categories of lending within alternative credit include direct lending, mezzanine distressed debt, and specialty finance. Capital may be loaned to an entity such as a corporation, or invested in an asset like real estate or infrastructure. This type of lending is well positioned to demand higher rates of interest due to the increased risk-exposure.

Alternative credit investments are primarily accessed through limited partnerships (LPs) that prohibit investors from redeeming their capital for a period of time (often years) after inception; however, some firms now offer hybrid structures, which provide exposure to illiquid assets but with greater liquidity for investors.

What is direct lending?

PIMCO refers to direct lending specifically as the practice of privately investing in senior debt, typically of middle-market corporations, with the investor essentially assuming the role of a traditional lender. The term can also be used to describe many forms of lending outside of corporate, including commercial real estate, residential real estate, and other consumer lending.

Similar to other alternative credit investments, this strategy can enhance investment portfolios by providing a differentiated source of return versus traditional credit. Investors may also expect to earn a premium in return for the illiquidity and increased complexity of their investment.

What is the J Curve?

Investors typically expect to receive a higher return over time from alternative credit than from traditional credit investments due to its illiquidity and complexity. However, similar to private equity, the return profile of some alternative credit strategies may follow a particular trajectory, often delivering negative returns and cash flows in the early years with the eventual goal of turning those into positive years after its launch. This pattern is referred to as the J Curve, so named because the shape of the curve resembles the letter “J” (see chart below). As a reminder, all investors should remember that there is no assurance that any investment will achieve its objectives, avoid loss or generate profits.

The J Curve may be relevant to some alternative credit strategies. It demonstrates the initial period of active investing when a private fund draws down a large portion of its available capital to invest. In turn, this causes a negative return and limited cash flow. After this initial investment period is finished, if and when the private fund begins to generate returns, there is the potential for a sharp increase in value causing the ‘uptick’ in the J Curve.

When investing in alternative credit strategies, it is important that investors are aware of the concept of the J Curve and the impact it can have on their overall portfolio outcomes. They must be comfortable with the potential loss that may be realized in the short-term in exchange for the potential for long-term gains.