Beyond the numbers: Delivering private credit’s advantages

Northleaf is an institutional investment manager, active in global private equity, credit and infrastructure. We got our start as part of TD Bank. We were pioneers in raising institutional capital to launch our first private equity fund in the early 2000s.

We became Northleaf in 2009 and in the years that followed, we launched our infrastructure and private credit businesses to complement our activities in private equity.

We have now raised over US$24 billion in commitments from more than 250 institutional and family office investors. We have nine offices in key markets across North America, the U.K., Asia and Australia. 

It’s really a natural progression from our private equity roots. We have a decades-long history of partnerships with top private equity firms in North America, the U.K. and Western Europe. Historically, these firms sourced debt for their leveraged buyouts from traditional bank lenders. But in the aftermath of the global financial crisis of 2007-08 and ensuing liquidity crisis, the banks began pulling back from this business, as they repaired their balance sheets to comply with stricter regulatory requirements.

This created a vacuum for private lenders, who gained significant market share. Private borrowers were still in need of capital to expand their businesses and private lenders were able to provide this capital with more flexible terms. The banks often employ a “one-size-fits-all” approach to underwriting. But private credit lenders are able to underwrite each deal based on the unique circumstances of the borrower.

Northleaf’s relationships in the private equity space facilitate direct access to many very attractive lending opportunities. The opportunity set among private companies is significantly larger than among public companies, particularly among mid-sized companies where we specialize. Northleaf’s consistent focus on the mid-market has provided our investors with high-quality lending opportunities at very attractive yields. 

Northleaf has a unique multi-channel sourcing strategy that provides access to a substantial pipeline of high-quality investment opportunities globally. Again, this goes back to our relationship with private equity investors. We primarily lend to companies that have been, or are being, purchased by private investors. These are highly capable, highly motivated and well-capitalized investors who build and grow these target companies on behalf of their own institutional clients before selling the business, hopefully at multiples of the purchase price.

These relationships, in addition to our team’s local offices and coverage in key global markets, provide us with a robust pipeline of more than 750 lending opportunities per year. We apply our disciplined underwriting process to select the best opportunities. We invest in less than 5 percent of the deals we see with a focus on finding the best relative value and building a robust, diversified portfolio for our investors. 

We focus our lending activities on companies in developed markets and in sectors with defensive, non-cyclical businesses. These businesses are characterized by stable demand for their products or services and predictable cash flows.

In lending, whether private or public, the real risk is capital impairment — something we spend a considerable amount of our time and resources to avoid. So that means we avoid lending to businesses in sectors like restaurants, travel and tourism, storefront retail, and anything directly linked to commodity prices.

We are focused on lending within sectors like health care, financials or software and services, where the products or services are critical to the operations of market-leading businesses. These are not necessarily glamorous businesses and some of these opportunities may be surprising to the average investor. For example, heating, ventilation and air conditioning (HVAC) businesses can have revenues that are highly predictable, because customers are less likely to change providers or be cost-sensitive when they have an issue with their HVAC system.

We also like sectors where the revenues are stable and unconnected to the economic cycle, such as health care and veterinary services, or those that have contractual revenue frameworks, like providers of critical software to blue-chip customers and government entities. 

The single most important development in our market over the past 18 months is the increase in base rates — those set by central banks like the Bank of Canada and the U.S. Federal Reserve. Northleaf’s private market loans are contracted on a floating rate basis — that is, the rate our borrowers pay is an amount above the base rate. This means our loan economics improve as rates rise. As such, our investors have been net beneficiaries of the increase in interest rates.

We’re also seeing that credit spreads are wider, a testament to the market’s perception of a heightened risk environment. Base rates have risen by over 500 basis points since the lows in early 2022, and the credit spreads and annualized fees we’re charging on new loans is up over 100 basis points. All told, we’re able to invest in new loans at gross asset yields of ~12 percent, before the impact of fund leverage. That rises to over 15 percent after the impact of leverage used in our fund. This attractive yield environment led us to increase the annual distribution on our senior, lower-risk lending fund to 10 percent in Q4 2022.

Let’s state up front that defaults may increase, both in public and private markets. Some businesses will struggle to service their debt given the rise in financing costs. There will be failures and some lenders will end up recovering less than 100 cents on the dollar in specific loan-default scenarios. However, we expect the impact to be more acute in cyclical industries and/or highly levered businesses, which is not our focus.   

But will it be worse in private credit than in public markets? Historically, that has not been the case. In the past, private markets have seen lower losses and higher recoveries, due to more conservative loan structures and stronger lender protections.

Importantly, even after factoring in a modest increase in defaults in private lending, we believe today’s attractive yield environment will provide investors with strong absolute and risk-adjusted returns relative to other fixed-income investments. The higher yield environment is serving to more than offset the modest uptick we expect to see in defaults and losses.

History has shown us that private credit has the potential to provide investors with a healthy yield premium over comparable high-yield public market investments, at a risk level that is much closer to investment-grade credit. As market yields rise, plateau and perhaps trend very slowly down over time, we believe Northleaf private credit strategies have the potential to offer yield-seeking investors a very healthy return. That’s coupled with the potential for strong annual cash distributions and historically impressive capital preservation compared to other higher-yielding types of fixed income.

Through our partnership with Mackenzie Investments, we are breaking down barriers for all Canadian investors by providing our institutional private market capabilities to individual accredited investors, offering advisors and investors an innovative way to reconstruct portfolios for a changing world.