Reward and risk: the growth of private credit markets

October 2024  |  COVER STORY | FINANCE & INVESTMENT

Financier Worldwide Magazine

October 2024 Issue

Every company requires funding to gain a foothold in business. But sourcing that funding can be challenging, particularly for those with no more than a nascent relationship with traditional lenders.

Beyond traditional lending sources, however, there is a plethora of alternative finance options available for entrepreneurs and established business owners to ponder as they search for capital.

These alternative options include, but are not limited to, debt crowdfunding, micro loans, crowdfunding, angel networks, asset finance, private and public equity, and early stage and development loans – all of which have come to the fore in varying degrees in recent years following the curtailing of traditional lending lines.

“Generally speaking, bank lending has dried up as a result of both the increased interest rates resulting from the economic policies implemented during the coronavirus (COVID-19) pandemic as well as recent banking crises such as that involving Silicon Valley Bank,” says Josh Kalish, a partner at Farrell Fritz. “This has created a substantial opportunity for private lenders to fill the void left by traditional debt financing.”

Filling this funding void for an increasing number of corporate borrowers is the private credit markets – a financing source that first emerged some 30 years ago to assist companies that were deemed too large or risky for commercial banks to deal with or too small to raise debt in public markets.

“Historically, loans over $300m were the domain of public markets, but private credit funds can now handle deals well over $1bn thanks to the record dry powder at their disposal,” adds Christopher Jeffery, general manager at Palico.

Private credit

As defined by the Federal Reserve, private credit or private debt investments are debt-like, non-publicly traded instruments provided by non-bank entities, such as private credit funds or business development companies, to fund private businesses.

Private credit is typically extended to middle-market firms with annual revenues between $10m and $1bn, but has grown rapidly in recent years to fund larger companies that were traditionally funded by leveraged loans. It typically involves the bilateral negotiation of terms and conditions to meet the specific needs and objectives of the individual borrower and lender, without the need to comply with traditional regulatory requirements.

What is more, this type of financing continues to expand. According to PitchBook, the private credit market topped $2.1 trillion globally in 2023 in assets and committed capital. About three-quarters of this was in the US (where its market share is nearing that of syndicated loans and high-yield bonds), with Europe accounting for the majority of the remainder.

“Private credit has grown quite quickly, primarily driven by direct lending strategies,” observes Nicholas Mairone, associate vice president of research insights at Preqin. “This growth started in the post-2008 world, with the growth rate picking up from 2015 to date. The outlook remains bright and it is forecasted that private credit assets under management will grow to $2.8 trillion by 2028.

“Some of the growth we have seen is due to the growth in private equity – direct lenders often lend to sponsor-backed businesses,” he continues. “Some of it is because of additional restrictions that limit some bank activity. In recent years, this trend has continued with direct lending being the largest strategy within private credit. That said, private credit remains small in the broader context of overall credit markets, with plenty of room to grow.”

Rewarding financing

A range of factors make private credit an attractive source of financing for corporate borrowers, including speed of execution (particularly desirable in volatile public market conditions) and confidentiality (negating the dissemination of proprietary information) – both of which are potential bottlenecks in the underwriting process for traditional lending institutions.

“Borrowers like private credit because of its flexibility and speed of execution,” concurs Mr Jeffery. “Underwriting turnarounds are lightning fast and these loans can be tailored to meet specific needs, such as customised repayment schedules and tailored covenants, which are often not available through traditional bank loans. Greater confidentiality is also why we are seeing widespread adoption of private credit among financial sponsors.”

In its 2022 ‘Understanding Private Credit’ analysis, Goldman Sachs outlines further factors, set out below, as to why private credit markets are increasingly becoming a magnet for borrowers.

First, income generation. Over the past decade, the asset class has generated higher yield than most other asset classes, including 3-6 percent over public high yield and broadly syndicated loans. Borrowers have been willing to pay a premium for the certainty of execution, agility and customisation that private lenders offer.

Second, resilience. Private credit typically features a single entity lending to a borrower. This can make for quicker and more efficient workouts – and potentially greater recovery – in case of default, compared to publicly syndicated debt placements that feature multiple lenders with competing priorities.

“Unlike liquid markets, the private credit space involves one lender and one set of documents,” adds Meghan Neenan, managing director and head of North American non-bank financial institutions at Fitch Ratings. “There are also meaningful benefits when a corporate borrower underperforms base case expectations, as renegotiations can be more tailored and efficient as there is no requirement to seek approval from numerous lenders as is necessary in a broadly syndicated transaction.”

Third, potential return enhancement. Aided by yield premium and resilience dynamics, private credit has outperformed public loans over the past decade, having delivered 10 percent annualised returns compared to an annualised 5 percent for public loans. In a rising-interest rate environment, private credit may find its floating rate nature a further advantage.

Fourth, diversification. Some private credit strategies are most directly exposed to the economic health of corporate borrowers, others to the consumer and some to real assets. Some strategies, such as performing corporate and real asset credit, tend to move with the economic cycle. Others, such as distressed and opportunistic strategies, may be more countercyclical.

An additional advantage of private credit is the availability of smaller ticket sizes for borrowers. “The traditional syndication market often looks for larger deals than private credit lenders, which can make private credit an option for certain borrowers,” explains Mr Mairone. “One other consideration may be that private credit lenders can work more closely with their borrowers, intervening early in periods of credit stress and potentially granting more flexibility.”

Risks and vulnerabilities

While the International Monetary Fund (IMF) contends that immediate financial stability risks from private credit appear to be limited, if its fast growth continues with limited oversight, existing vulnerabilities could present risks for both investors and borrowers, as well as systemic risk for the broader financial system.

Among the risks involved in migrating from regulated banks and relatively transparent markets to the opaque world of private credit are those highlighted by the IMF in its 2024 ‘Global Financial Stability Report’, as outlined below.

First, the sector could experience large, unexpected losses in a downturn. Private credit is typically floating rate and caters to relatively small borrowers with high leverage. Such borrowers could face rising financing costs and perform poorly in a downturn.

Second, liquidity risk could rise with the growth of retail funds. The great majority of private credit funds poses little maturity transformation risk. However, the growth of semiliquid funds could increase first‐mover advantages and run risks. Increasing retail participation in private credit markets raises conduct concerns as retail investors may not fully understand the investment risks or the restrictions on redemptions from an illiquid asset class.

Third, multiple layers of leverage create interconnectedness concerns. While private credit funds appear to use limited amounts of leverage, they are also often part of a complex network that includes leveraged players ranging from borrowers to funds to end investors. These multiple layers of leverage, often hidden by reporting gaps, could magnify losses. In addition, funds may still face significant capital calls, with potential transmission to their leverage providers.

Fourth, uncertainty about valuations could lead to a loss of confidence. The opacity of borrowing firms and the fact that the sector has never experienced a severe economic downturn at its current scope and size make prompt assessment challenging for outsiders. Fund managers may be incentivised to delay the realisation of losses as they raise new funds and collect performance fees based on their existing track records.

Fifth, risks to financial stability may also stem from entities with particularly high exposure to private credit markets. Such entities include insurers influenced by private equity firms and certain groups of pension funds. The assets of private equity controlled insurers have grown significantly in recent years, with these entities owning significantly more exposure to less liquid investments than other insurers.

Lastly, assessing the overall financial stability risks of this asset class is challenging because of data limitation. If the asset class remains opaque and continues to grow exponentially under limited prudential oversight, the vulnerabilities of the private credit industry could become systemic.

“The risks to investors in private credit deals can vary widely depending on the underlying credit profile of the borrower as well as the seniority of the particular credit in the borrower’s debt stack,” observes Mr Kalish. “For example, venture lenders of software companies charge high interest rates as well as other fees to compensate for the default risk.

“In addition to a borrower’s credit risk, investors also assume the risk that, in a default scenario, the collateral may be difficult to liquidate, and therefore, lenders can end up in the undesirable position of taking control of assets that require specialised knowledge to operate,” he continues. “This, in turn, could require them to work out a deal with the existing management team to stay involved, the cost of which in certain scenarios could reduce, or at a minimum delay, the potential recovery available to lenders.”

Regulatory vigilance

Given its limited oversight, the expansion of private credit raises questions around the wider compliance and regulatory framework for private credit funds, and how existing regulations can be applied to fund managers.

In the view of the IMF, there should be a more intrusive supervisory and regulatory approach to private credit funds, their institutional investors and leverage providers. This includes enhancing cross-border and cross sectoral cooperation to address data gaps and make risk assessments more consistent across financial sectors.

Closing of data gaps should also be prioritised so that supervisors and regulators may more comprehensively assess risks, including leverage, interconnectedness and the buildup of investor concentration. Regulatory authorities should also enhance reporting requirements for private credit funds and their investors, and leverage providers to allow for improved monitoring and risk management.

Also important for regulators, according to the IMF, is to monitor closely and address liquidity and conduct risks in funds that may be faced with higher redemption risks. Moreover, securities regulators should implement relevant product design and liquidity management recommendations from the Financial Stability Board and the International Organization of Securities Commissions.

“We are already seeing regulators take a more watchful approach to this market over concerns that it does not have enough oversight,” notes Mr Jeffery. “As part of its overhaul of the Alternative Investment Fund Managers Directive, the European Union has adopted new rules for private credit managers, capping their use of leverage and putting limits on their borrowing to avoid loan concentration risk, as well as certain retention requirements so that excessive risk is not passed on to third-party investors.”

Continued traction

Despite global economic uncertainty marginally slowing the pace of private credit fundraising during the first quarter of 2024, the general consensus is that opportunities abound for private credit borrowers and investors, with a variety of markets offering the right balance of reward and risk.

“The first quarter blip may be temporary and reflect the volume of capital that has already been raised at a time when M&A is still relatively muted, hampering capital deployment,” suggests Mr Mairone. “The longer view is that these funds have cemented their position as go-to providers of debt, especially in the mid-market. That has taken well over a decade to play out, so it is hard to believe that will change. The product market fit is clearly there.”

Also confident is Ms Neenan: “Private equity firms have held onto investments for far longer than normal and have a significant amount of capital to deploy,” she points out. “As fund investors continue to clamour for a return of capital, a recovery in deal activity will eventually take hold, providing for an increase in private credit activity. This rebound would be expected to benefit private credit activity for some time.”

With no obvious indicators that the appetite for private credit is shrinking or likely to decline markedly any time soon, it seems clear that as long as the market continues to be flexible and innovative, it will continue to grow and enjoy significant market share.

© Financier Worldwide

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Fraser Tennant