May 2017
VIII. Focus on Private Credit to Capture the Illiquidity Premium
Private credit markets continue to be impacted by a deleveraging banking system, financial austerity and limited non-bank sources of capital. The current
supply/demand imbalance in private lending provides a reasonably rich illiquidity premium and presents attractive risk-adjusted investment opportunities for
patient capital.
Context
• Post financial crisis, regulation has constrained banks and other
traditional lenders from providing credit; additionally, banks have
been forced to deleverage their balance sheets
• However, demand for private financing remains strong as smaller
companies and distressed entities continue to need access to
credit in a more regulated environment
• Along with the record size of the HY market, energy is no longer
the only sector experiencing weakness. Default rates are expected
to continue to rise
Commercial and Industrial (C&I) Corporate Loan Demand Is Rebounding
off 2016 lows
As of 4Q 2016 estimate
40%
20%
0%
-20%
-40%
-60%
2006
2008
2010
2012
2014
2016E
C&I Corporate Loan Demand (net percent balance)
Investment Thesis
Private Credit Dry Powder Has Been Rising Steadily
• Bank regulation and deleveraging continues to create opportunity
for non-bank entities to provide bespoke financing
• We believe the private credit markets can help fill the void in the
current debt supply/demand imbalance
• There is about $579 billion1 in middle-market debt that will mature
and will need to be refinanced in the next five years and about $535
billion2 in private equity dry powder that will likely spur loan
demand as this money is invested
• The pockets of distress in the secondary credit markets create
opportunity for investors to take advantage of the dislocations and
the potential for higher yields at the margin
As of April 3, 2017
250
150
100
50
2016
Apr-17
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
0
2003
$ (bn)
200
Private Credit Capital Avaliable for Investment
Source: Morgan Stanley Wealth Management GIC, Preqin, Haver Analytics. (1) Thomson Reuters data as of December 31. 2016. (2) Preqin. Data for the buyout segment as of April 3, 2017
Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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May 2017
VIII. Focus on Private Credit to Capture the Illiquidity Premium
•
Investment Ideas
Key Risks
• Investors who can bear the illiquidity may look to direct lending as
a way to supplement their fixed income portfolio
• Focus on managers originating loans to small- and mediumsized companies; financing can come in the form of senior
secured, second lien, and mezzanine
• Private credit investments can carry prepayment and
origination fees as well as equity kickers (i.e., warrants), which
have the potential to enhance returns
• Focus on pools of non-performing loan opportunities spurred by
bank deleveraging
• Seek out managers who invest on a control and non-control basis
in distressed US corporate credit in sectors that are over-levered,
including restructuring / bankruptcy processes
• Consider relative value credit hedge fund managers that can take
advantage of movements across yield curves and credit spreads
based on the present macro picture and supply/demand dynamics
• Manager skill in their ability to source, underwrite, and manage
risk is critical
• Fund managers may utilize leverage and typically do not hedge
• Middle-market debt is illiquid, with no established secondary
market available to provide liquidity to lenders; additionally, the
funds investing in this debt do not provide liquidity to investors
aside from the periodic coupon payments
• A deterioration in the macroeconomic environment may lead to an
increase in defaults in direct lending strategies
• Upside in the macroeconomic environment could potentially limit
the investment opportunity set for distressed credit managers
Source: Morgan Stanley Wealth Management GIC
Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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May 2017
Hedged Strategy Definitions
Relative Value Investment managers in this strategy maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple
securities. They employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivatives or other security
types.
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Certain of these risks may include but are not limited to: Loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices; Lack of liquidity in that there
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Wealth Management engages in a broad spectrum of activities including financial advisory services, investment management activities, sponsoring and managing private investment funds, engaging in
broker-dealer transactions and principal securities, commodities and foreign exchange transactions, research publication, and other activities. In the ordinary course of its business, Morgan Stanley Wealth
Management therefore engages in activities where Morgan Stanley Wealth Management’s interests may conflict with the interests of its clients, including the private investment funds it manages.
Morgan Stanley Wealth Management can give no assurance that conflicts of interest will be resolved in favor of its clients or any such fund. Alternative investments involve complex tax structures, tax
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Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
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Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.
Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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May 2017
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Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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