In financial news, private credit has become one of the hottest topics of the year.
By now, you’ve probably seen the deluge of Bloomberg articles, heard the symphony of interviews and panels from fund managers, and maybe even been curious about how to participate yourself.
The buzz is fully justified- private credit has grown enormously over the past few decades, with more than a six-fold increase since 2008 to a current global total of $1.6T assets under management. This growth has shown no signs of stopping, with BlackRock forecasting a 15% compounded annual growth rate, to reach $3.5T by the end of 2028.
Why is this happening? What is the appeal of private credit, and what is driving the increased attention by institutional investors? In this article, we will take a look at what private credit is, its history as an asset class, some of the benefits it has to offer to borrowers and lenders, and finally, what the future may hold.
What is Private Credit?
First, let’s take a look at what private credit is and the place it has compared to similar alternative assets like its close relative, private equity. Simply put, private credit refers to non-bank lending to corporations. Lenders include large firms like Apollo, Blackstone, and KKR, as well as asset managers, family offices, and pension funds. As for the borrowers, they tend to be private middle-market ($10-100M EBITDA) corporations who require capital for a variety of different reasons, including private equity acquisition financing.
Private credit and private equity go hand in hand. Private equity firms seek to undertake leveraged buyouts (LBOs), where the acquisition of a company is financed mostly by debt instruments, as opposed to equity. Debt can comprise anywhere from 60-90% of acquisition financing. This debt has a lower cost of capital than equity, and is used to increase the rate of return for equity investors, as the leverage employed increases both the risk and the possible return.
Hence the name- these are highly leveraged transactions that carry a high degree of risk, as equity holders may be left with nothing if the company is unable to pay down the interest payments. Examples of the dangers involved include the infamous Energy Future Holdings buyout– where $45B, of which $40B was debt, was spent to acquire Energy Future Holdings, which filed for bankruptcy protection just a few years after. Today, LBOs are typically less risky in terms of size and leverage employed, but they still require suitable lenders who are willing and able to finance higher-risk deals.
That’s where private credit comes in. Private credit lenders can provide the financing needed to undertake these acquisitions as lenders who are able to be more flexible and adaptable than banks can be. This has led to the prevalence of private credit in LBO financing, growing from 65% of LBO financing in 2021 to a dominating 86% in 2023.
LBOs aren’t the only use case for private credit, of course. Firms often look for direct lending as a way to fund business expansions, capital expenditures, or ongoing operations. In some cases, companies seek financing for special situations- such as a merger, acquisition, or spin-off.
Additionally, distressed companies, who are at a high risk of bankruptcy or default, may seek private lending as an attempt to recover. This “junk debt” comes with many benefits for fund managers including high yields, conversion rights to equity, and senior placement in the capital structure- to go along with the high default risk.
Now that we’ve examined the role of private credit as an asset, let’s look at the history of the asset class.
The History of Private Credit
Let’s set the clocks back to 2010. The global financial crisis had just occurred, and the entire world witnessed the effects that risky loans and subprime lending had on institutionally important banks. Regulators looked to reign in risky activity, culminating in the Dodd-Frank act and similar legislature that eventually pushed banks away from much of traditional corporate lending. The 2013 Guidance on Leveraged Lending, intended to reduce systemic risk in the banking system, limited the ability of banks to issue leveraged loans by capping leverage ratios and setting timelines on debt reduction following acquisition. These factors left a gap in bank
financing- both for private equity funds looking to undertake LBOs, and companies themselves, who were seeking to raise debt.
In the interim, private credit arrived. Catering to companies needing financing, private credit stepped in to provide debt with more flexible terms. Not subject to the stricter regulations and increasingly “de-risking” focused philosophies of banks, non-regulated lenders were able to gain market share and grow the asset class as a whole from a mere $238B in 2008 to the 1.6T asset class it is today.
We’ve touched upon the flexibility inherent in private credit, but what other factors make it so appealing?
Advantages of Private Credit for Borrowers
Firstly, borrowers see private debt as a way to find custom solutions for their financing needs. Publicly syndicated debt requires time and management attention: investor roadshows, filings, and other compliance requirements that delay the speed of financing, which is often needed in a company’s most crucial moments. Additionally, it requires these companies, many of whom are private, to open up their books and reveal proprietary information.
Private debt provides an easier solution: because many of the lenders have a 1-1 relationship with borrowers, do not resell (syndicate) the debt publicly, and are not subject to the same compliance restraints that banks might be, it’s easier for custom solutions to be formed as a win-win, where firms often continue to work with one another through a variety of deals. Single entity lending is easier for companies who cannot compete with publicly syndicated debt, and allows companies to explore complex arrangements including paid-in-kind components and custom-built covenants. Additionally, smaller companies who lack access to public debt markets find a way to generate financing with a certainty of execution.
So, the advantages are clear for borrowers- but what’s in it for lenders?
Advantages of Private Credit for Lenders
There are a wide range of benefits for investors as well. First, note that one of the key defining traits of private credit is illiquidity. It’s very difficult to have others take on private debt positions, and there is no public market for the debt- meaning that private credit comes at a large illiquidity premium. For institutional investors who have the capacity and appetite for long-term, illiquid assets, private credit can substantially increase return.
Take long-term holding investors like pension funds for example- who make up a total of 28% of private credit holders. In the case of these pension funds, their clients have long-term, predictable, and stable outlooks that reduce the risk of early investor withdrawal. Endowments, insurance companies, and other investors with similar outlooks are able to remain patient, and take the higher yield as a bonus.
Another key benefit is diversification: private credit has low correlation with other asset classes and the overall market. For equity portfolios, this means access to steady cash flows, granting stability amongst volatile markets. To put it another way, traditional portfolios have long-relied on a 60-40 mix of equity to fixed income. The historical reasoning is that equity holdings provide growth and potential upside, with bonds providing stability and consistent income. During recessions, where the Fed cuts interest rates, bonds increase in value, as they are worth more relative to newly issued, lower yield bonds. Of course, when the market grows, the equity portion of the portfolio rises, creating a balanced return overall.
Since 2021, this philosophy has faltered. The stock-bond correlation became positive, in part due to an inflationary environment where inflation both reduces the real value of bonds and also reduces equity prices through the expectation of rate hikes. This means a higher degree of diversification through alternative assets may be needed. Enter private credit- as a way to add a fixed income source more focused on intrinsic company fundamentals and less correlated with the overall markets than government bonds are during times of recession. Additionally, private credit generally operates on a floating rate basis- meaning that in high-rates environments, private credit can adapt and maintain value where fixed-rate bonds are more sensitive.
Of course, the key benefit for many simply lies in the high risk-adjusted returns. Historically, private credit has substantially outperformed public markets as compensation for the added risk and accommodation given by fund managers. The Cliffwater Direct Lending Index, an asset-weighted index of 13,000 middle-market loans, shows that private debt has outperformed both the USD HY Corporate Index and the Morningstar Leveraged Loan Index in 13 of the last 18 years. As a whole, the asset class performs 3-6% over public options, with a high yield premium that makes it a very attractive alternative to syndicated debt investments especially as rates rise.
Lastly, the custom nature of the debt runs both ways: fund managers are able to preserve the credit rating of their debt by controlling management through covenants and relationship building. Recovery is made easier by the fact that they are a single lender, meaning no competition with public syndicated debt and usually a more senior position in the capital structure. Finally, there are options for asset-backed and secured loans to further reduce risk. These factors have kept loss rates competitive to the public markets, with defaults actually falling below the USD HY since 2012.
Of course, all private credit comes with risks. As an inherently illiquid asset, manager diligence becomes incredibly important: it’s hard to exit positions, and funds are often stuck with poorly performing debt on the books. The average loan life, according to the Cliffwater Direct Lending Index, has increased to 5.8 years in recent times- presenting additional liquidity issues for investors. While this is largely mitigated by self-selection from institutions who can tolerate this, funds must also consider holding short-term fixed income or more liquid assets to be able to facilitate investor demands.
Reuters : John Gress
Additionally, the lack of public info means that fund-specific valuation techniques and due diligence becomes more important. Many borrowers are too small for ratings agencies like Moody’s, so offerings are unrated. You have no “market opinion” to fall back upon- and while the information available to you can be greater (as private companies are able to provide more
info to you than they would for broadly disseminated public offerings), overall confidence and willingness to venture into unexplored territory is key to decision making, and subsequent success or failure. Large players in the field like HPS are willing to bet on their numbers and the ability of their management.
With all this said, what does the future hold? Expert opinion from Goldman Sachs, BlackRock, Blackstone and other firms say that private credit will only continue growing.
The collapse of regional banks like SVB and First Republic may be signs of further expansion to come. Increasing U.S regulations will further reduce the ability of banks to provide loans, and make banks move existing loans off of balance sheets- creating more demand for private lenders. Especially for non-profitable companies, like many of the tech startups formerly financed by SVB’s venture debt activity, private credit looks to be the only option in an environment where banks continue to shy away from riskier credit.
Additionally, the consensus of many investors shows both a greater amount of funds entering PC, and higher allocations for those already in the asset with 45% of Preqin’s June 2023 survey respondents planning to commit more capital to private debt
It’s interesting to see what the future has in store for Private Credit- and the broader implications for the economy as a whole.
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