PRIVATE MARKET INSIGHTS

PRIVATE CREDIT: STABLE RETURNS, DOWNSIDE PROTECTION

Allocations to private credit funds have grown rapidly in recent years. In simple terms, these funds partner with private equity fund managers or other investors – known as lead sponsors – to invest in private companies whose limited size makes accessing public debt markets problematic. Private credit funds can operate across the full spectrum of the capital structure, though most funds follow strategies focused on one specific debt type or range of debt types. Returns are generated via cash interest on the loans, supported by call protections*. Certain strategies may also include equity ownership elements to benefit from company growth.

Private credit funds have seized on the opportunity presented by commercial banks scaling back lending to both smaller private companies and lead sponsors. This was due in large

part to regulatory tightening across the globe. As a result, private credit funds have become the preferred source of financing for lead sponsors looking to execute deals in this market segment. Meanwhile, sophisticated limited partners, such as fund-of-funds managers, also account for a rising share of the private credit financing market – approximately 3-5% of the market.1 We expect this share to continue to rise, as established relationships with financial sponsors often drive debt financing allocation decisions.

On the investor side, appetite for investing in US private equity funds operating in the middle market continues to strengthen, with dry powder for these fund types reaching $339.6 billion as of March 5, 2019, up from $206 billion in 2012.2

* A call protection is a provision that sets prepayment fees to protect against the risk of early debt repayment.

1 Preqin, data as of May 30, 2019

2 Preqin. Middle-market funds defined as having under $2 billion of total commitments. Middle-market companies defined as having an EBITDA of less than $100 million. EBITDA = Earnings before interest, taxes, depreciation, and amortization.

PRIMER

AUGUST 2019

PRIVATE CREDIT: STABLE RETURNS, DOWNSIDE PROTECTION / page 2

Private Market INSIGHTS

WHY INVEST IN PRIVATE CREDIT?The investment opportunity offered by lending to the middle market, a segment of the economy that accounted for roughly 50 million jobs in the US in 2018 and more than one-fifth of GDP, is compelling (see Chart 1). In addition to being financially underserved, this market segment is opaque and fragmented compared to public markets, and these inefficiencies can create investment opportunities and the potential for strong investment returns. To help put the scale of this opportunity in context, in 2018 US middle-market private credit loan issuance totaled $183 billion.3

From the perspective of a private market investor, private credit funds have characteristics that may make them an excellent complement to their existing portfolio. These benefits can include:

> Capital preservation – based upon private credit’s position in the capital structure, which is senior to publicly-issued debt and common equity

> Portfolio diversification – differentiated exposure and a greater number of investments made versus most private market funds

> Downside protection – lower default and higher recovery rates over time

> Cash coupon – generating current income, generally on a quarterly basis

> Short duration – shorter average life resulting in quicker investment period than publicly traded fixed-income instruments

> J-curve** mitigation – with a yield component driving earlier returns to investors

DIVERSIFIED EXPOSURE Private credit funds generally offer broad diversification across industries, borrowers, and, for those focused on sponsor-backed transactions, financial sponsors. Due to the more collaborative nature of private lending – with multiple lenders often ‘clubbing up’ to provide a financing package for a single deal – typical individual transaction sizes tend to be smaller than in most other private market funds. Private credit funds have on average 20 to 40 underlying investments, which may offer an investor access to a broader range of sectors and deal types than other strategies.

More broadly, diversification, both across and within asset classes, is a crucial element of portfolio construction and has been shown to help improve risk-adjusted returns. (see Rethinking Risk: The Myth of Over-diversification).

Private credit offers exposure to an opportunity set that has little overlap and limited correlation with most other private market strategies, which can make it an attractive complement to traditional portfolios.

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> Chart 1: The significant scale of the US middle market relative to major world economies GDP, $ trillions, 2018

Source: US Center for the Middle Market, Heritage Foundation, World Bank, as of December 31, 2018. Middle market defined as businesses with revenues between $10 million and $1 billion.

** The J-curve is the typical shape adopted by the annual returns from a private equity fund during its lifecycle when graphed

3 Refinitiv LPC

PRIVATE CREDIT: STABLE RETURNS, DOWNSIDE PROTECTION / page 3

CAPITAL PRESERVATION AND DOWNSIDE PROTECTIONPrivate credit is senior in the capital structure to equity, which confers many benefits in terms of capital preservation. For starters, the nature of the underlying assets means that returns from private credit funds tend to be more predictable than those from other private market strategies, while the seniority of the debt – meaning it gets paid back prior to other debt types – offers downside protection (for more detail, see “The Capital Structure” on p.6). In addition, private credit funds typically lend capital at a less than 60% loan-to-value† ratio, and usually include floating rate structures, often LIBOR†† plus a fixed basis-point spread. The floating rate component helps protect returns in the event of inflation and rising interest rates. Terms also usually include negotiated contractual covenants that provide varying degrees of protection for the lender via guidance as to permissible financial actions on the part of the borrower. These protections are identified and negotiated as part of the extensive due diligence undertaken in leveraged buyout and refinancing transactions.

All of the above factors have the potential to help reduce default rates and boost recovery rates from middle-market lending – even among the worst-performing assets (see Chart 2).

CASH YIELD AND J-CURVE MITIGATIONPrivate credit generally offers steadier cash flows than most other private market strategies, due to a relatively large yield component derived from the payment of a cash coupon on a quarterly basis. These coupons start generating returns much earlier in the life of the fund than is possible with traditional private equity, helping to mitigate the J-curve effect. Further J-curve mitigation stems from fees generally being charged on invested capital rather than committed capital, and the typical duration of private credit investments being short relative to other strategies, which means they may be able to deliver returns to investors sooner.

Left Chart Source: S&P LCD (Q4 2018). Based on loans in the S&P/LSTA Leveraged Loan Index. Sponsored loans defined as those led by a private equity sponsor.

Right Chart Source: Pension Consulting Alliance (March 2018 [latest available data]). Based on S&P Credit Pro data. Recovery rate calculated as the value received in settlement, discounted at the effective interest rate on the instrument, as a percentage of the principal default amount. Past performance is not a reliable indicator of future results.

† The loan-to-value ratio is a measure of the value of a loan relative to the value of the asset being purchased. †† LIBOR is the London Inter-Bank Offered Rate, an international benchmark rate reflecting the cost of inter-bank lending.

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> Chart 2: Low default rates and high recovery rates of middle-market loans

Average Lagging Twelve-Month Default Rates by Principal Amount, 1998-2018

Recovery Rates by Asset Class, 1989-Q1 2018

> Chart 1: The significant scale of the US middle market relative to major world economies GDP, $ trillions, 2018

Returns from private credit funds tend to be more predictable than those from other private market strategies.

PRIVATE CREDIT: STABLE RETURNS, DOWNSIDE PROTECTION / page 4

Private Market INSIGHTS

SELECTING A PRIVATE CREDIT MANAGERWhen selecting a manager for a private credit allocation, a track record of strong and consistent performance is an obvious consideration but should not be the only one. In our experience, key criteria for assessing managers include:

BROAD DEAL-FLOW PIPELINE AND ESTABLISHED RELATIONSHIPS An excellent investment thesis is only as good as a manager’s ability to execute it. When allocating to private credit managers, it is important to consider how they generate deal flow.

When considering managers executing financial sponsor-focused strategies, the breadth and depth of a manager’s existing relationships with potential lead sponsors and lenders is of paramount importance. Extensive and longstanding relationships can help generate a wider and more diverse funnel of investment opportunities, and may improve the chances of accessing potentially highly competitive deals.

In the non-sponsored arena, the ability to generate investment opportunities without relying on sponsor relationships is a key differentiator and requires an established, well-defined deal origination capability.

Flexibility is also important. A manager must be able to perform comprehensive due diligence even in time-sensitive scenarios and provide solutions across the capital structure, including debt and/or equity.

By generating a broad deal-flow funnel and providing flexible financing solutions, a manager should be able to secure allocations to desirable deals and minimize adverse selection.

COMPREHENSIVE DUE DILIGENCE PROCESSESCredit-focused due diligence is a highly complex process that demands extensive data analysis. Investors should seek out managers who have a clearly differentiated ability to evaluate lead sponsors, as well as the resources necessary to undertake due diligence from multiple angles. These desired capabilities include:

> Scrutiny of lead sponsors, both broadly (overall track record) and narrowly (deal-level information)

> Information on specific private market sector and sub-sector returns and valuations

> Wide-ranging opportunity analysis, including customer-level due diligence, third-party consultant and expert network access, and macroeconomic research

> Deep review of individual loan structure and accompanying documentation

DISCIPLINED PORTFOLIO MANAGEMENTIn private credit, as with all private market asset classes, post-acquisition portfolio management is vitally important, especially when constructing a diversified portfolio of underlying loans. Investors should look for private credit managers with proven records of collaboration with lead sponsors, as well as established, systematic processes for engaging with and enhancing the companies in their portfolio. Managers should have experience and tangible plans to deal with work-out‡ scenarios when they occur.

INVESTOR-FRIENDLY FEE STRUCTUREWithin private credit, many funds offer fee structures based on invested capital, rather than committed capital, helping to lower costs for investors. This reflects the lower absolute and relative returns of the asset class versus the broader private market investment universe. In addition, investors may want to pay attention to whether fees are calculated inclusive of leverage when it is employed to enhance returns. Finally, investors should seek fee structures that mitigate the J-curve effect and funds that emphasize a disciplined investment pace.

An excellent investment thesis is only as good as a manager’s ability to execute it.

‡ A work-out agreement is a mutual agreement between a lender and borrower to renegotiate terms on a loan that is in default, and may include restructuring its terms and covenants.

PRIVATE CREDIT: STABLE RETURNS, DOWNSIDE PROTECTION / page 5

REASONS FOR CAUTIONAs with any asset class, it is important for investors to understand the potential risks of investing in private credit, which include:

CAPITAL RISKPrivate credit is generally viewed as having an attractive risk profile versus other private and public markets options. The returns generated by the top private credit managers are credit-enabled and therefore do not rely on growth rates, acquisitions, or turnaround processes. However, as with any investment there is a chance that invested capital may be lost.

RELATIVE ILLIQUIDITYWhile private credit investments are an excellent complement to other private market strategies, they are not readily tradeable and generally take several years to exit or mature. An investor should consider their illiquidity tolerance before investing in the asset class.

ECONOMIC CYCLESAs with all asset classes, investors need to understand and plan for the impact of economic cycles on the anticipated performance of underlying investments. If executed correctly, however, private credit offers good downside protection and can diversify the sources of return and risk in a portfolio. For example, returns for traditional fixed-income securities are determined by the risk premiums related to credit quality, interest rates, and inflation. Private credit is less affected by those factors, which helps limit volatility.

If executed correctly…private credit offers good downside protection and can diversify the sources of return and risk in a portfolio.

PRIVATE CREDIT: STABLE RETURNS, DOWNSIDE PROTECTION / page 6

Private Market INSIGHTS

THE CAPITAL STRUCTUREUnderstanding the capital structure helps explain the investment characteristics of private credit funds, particularly their improved risk profile relative to public debt instruments and equities.The capital structure of a company details the scale of the different sources of capital used to finance its operations. Private credit funds can invest in a range of debt types across this capital structure, all of which have different risk-return profiles.

Senior Debt – First Lien: The most senior debt in the capital structure, meaning it will be the first to be repaid, whether a company finds itself in a financially distressed position or not. First-lien debt is secured against one or many assets of the borrower and may have negotiated covenants to guide behavior and protect the investment. It includes cash coupons that accrue interest on a quarterly basis. First-lien debt is typically structured with a floating rate linked to LIBOR to guard against inflation and interest rate rises.

Unitranche: A form of debt issuance that combines first and second lien debt into one tranche. The agreement therefore typically reflects a blended

pricing of the two liens and may be provided by one lender or multiple lenders that reach an agreement on key terms among themselves.

Senior Debt – Second Lien: Like first-lien debt, it is secured against assets, but is junior in terms of repayment rights. This higher risk is compensated for by an increased coupon on the loan.

Mezzanine Debt: Senior in the capital structure to equity and generally offers the highest target return range of any private debt investment. However, it is the most junior form of private credit and carries greater risk. Mezzanine debt agreements still typically seek structural protections to compensate for this additional risk.

Equity: Either preferred or common, equity comprises the remainder of the capital structure, and is junior to all forms of private credit investment, though it may offer significant upside. To this end, some private credit funds, especially those focused on mezzanine and subordinated debt, may seek warrants‡‡ or equity co-investments.

Source: HarbourVest. Example Unlevered Gross Annual Returns are Internal Rate of Return on a gross basis over a five-year period. Shown for illustrative purposes only. These estimates reflect the current expectations for the market. The ultimate investment pricing and terms will differ based upon market conditions and available investment opportunities. Not intended to project performance. Investments in private funds involve significant risks, including loss of the entire investment.

‡‡ A warrant is a derivative that gives the right, but not the obligation, to buy or sell a security at a certain price before a set expiration date.

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> First lien loans> Repaid first in event of financial distress> Secured by first lien against the assets of borrower> Structural and financial covenants to protect investment

> Unsecured or subordinated loans> Usually have covenants to protect against default> Repaid after secured debt> May include equity warrants

> Second lien loans> Repaid after senior debt> Sometimes referred to as "Term B" loansSenior Debt -

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> Chart 3: Sample private capital structure

SUMMARYThis primer on private credit has highlighted the rapid growth in allocations to the asset class among institutional investors, and the outlook for continued growth is promising as private equity involvement in the middle market looks set to increase. We also examined the potential merits of investing in the asset class, including capital preservation, diversified investment exposure, downside protection, cash income, and J-curve mitigation. In the hands of a skilled and experienced fund manager, private credit can offer attractive returns and relatively low levels of risk. Each of these characteristics makes a powerful argument for investing in private credit.

In addition to these individual benefits, allocating to private credit could also help augment and improve the risk profile of your broader private market portfolio. Optimizing a portfolio is no simple task, but our research suggests that diversification should be a foundational component of how you think about asset allocation. Allocating across different strategies, geographies, vintage years, managers, and industries may help to reduce risk and maximize risk-adjusted returns.

To find out more about investing in private credit, its role in a balanced portfolio and how it could help you achieve your investment goals, please get in touch with your HarbourVest contact or email clientservice@harbourvest.com.

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HarbourVest is an independent, global private market investment specialist with 36 years of experience and more than $64 billion in assets under management, as of June 30, 2019. The Firm’s powerful global platform offers clients investment opportunities through primary fund investments, secondary investments, and direct co-investments in commingled funds or separately managed accounts. HarbourVest has more than 500 employees, including more than 125 investment professionals across Asia, Europe, and the Americas. This global team has committed more than $37 billion to newly-formed funds, completed over $21 billion in secondary purchases, and invested over $11 billion directly in operating companies. Partnering with HarbourVest, clients have access to customized solutions, longstanding relationships, actionable insights, and proven results.