NEED a loan for a new factory or a buyout deal, but don’t like the terms your bank is offering? There’s a US$1.7 trillion industry that’s ready to help. Private credit came of age after the 2008 financial crisis as an alternative to banks at a time when regulators were clamping down on risky lending by deposit-taking institutions.
Today, it’s become a serious rival to mainstream lending for all kinds of businesses, from real estate firms to tech startups. Money is pouring into private credit funds from wealthy investors, retirement plans, sovereign wealth funds, and even the banks that compete with them. Some have argued that private credit should become a permanent fixture in capital markets and investment portfolios. Yet it’s not clear how this opaque corner of finance will cope when the next big recession hits.
What is private credit?
The origins of private credit can be traced back to the 1980s, when insurance companies began lending directly to companies with strong borrowing records. Today, private credit funds deploy billions of dollars in a variety of investing strategies:
- Direct lending: Companies borrow directly from a non-bank lender acting alone or as part of a small group. They typically hold the loans to maturity.
- Distressed debt: Private credit funds snap up corporate debt that’s trading well below its original value, or provide new financing to a company in difficulty, hoping to turn a profit as the business restructures or liquidates.
- Venture debt: Financing is offered to startups that have yet to make any profit. The loan size is typically based on a multiple of a firm’s recurring revenue.
- Mezzanine finance: This refers to investments in higher-risk forms of debt that sit between other loans and equity in the queue for repayment when a borrower can’t meet their obligations.
- Special situations: This covers loans extended to take advantage of a particular event or situation and where lending decisions are often not related to a company’s fundamental metrics such as profitability or growth.
How big is private credit?
Private credit funds have been able to take advantage of volatility in credit markets and periods during which banks were saddled with unprofitable loans to gain market share. Data company Preqin said closed-end private debt funds using the five lending strategies detailed above had around US$1.7 trillion of assets under management globally as at June 2023, up from around US$500 billion at the end of 2015. Money manager BlackRock said in October that “tectonic shifts” in financial markets would spur more borrowers to seek out private funds, boosting the value of the global private debt market to US$3.5 trillion by 2028.
What’s the appeal for borrowers?
Private credit funds say they can accommodate borrowers whose credit metrics make them ineligible for a bank loan (as is the case for many fast-growing but loss-making companies) or that require very flexible terms. Another advantage is that the pricing of private deals is often set up front. (With regular syndicated loans involving many lenders, the price can often fluctuate before the deal closes.) Execution can also be easier than with traded leveraged loans, where pricing is more susceptible to swings in the market. With the rise in global interest rates putting many companies under financial strain, some have chosen private credit instruments that allow them to defer interest payments, in arrangements known as payment in kind.
What’s been happening to private credit?
Interest rates rose so rapidly from early 2022 that banks were left with a backlog of unprofitable loans for buyout deals that they’d arranged before the hiking cycle began. As a result, they held back from more lending and focused on selling some of that hung debt. Private credit funds stepped in, taking on new loans and mopping up debt that banks weren’t able to sell to asset managers. Today, the available resources of private credit funds are often on par with those of large bank syndicates. Several funds organised a US$5.5 billion debt package in early 2023 to facilitate a potential leveraged buyout of healthcare technology company Cotiviti, though the deal never closed. In November, a consortium of funds including Canada Pension Plan Investment Board, Blackstone’s credit unit and Singaporean sovereign wealth fund GIC agreed to provide a 4.5 billion euros (S$6.6 billion) loan to back the buyout of European classified ads company Adevinta – an industry record. Even banks, whose retrenchment provided a growing space for private credit, are getting in on the game, with JPMorgan Chase, Societe Generale and others dabbling in private credit investments.
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Why invest in private credit?
Investors receive relatively high returns to compensate them for holding assets that can be harder to sell than traded loans. Direct lenders can charge between 200 and 300 basis points more than a bank syndicating debt for a similar company. Getting involved in private credit is also a way for investors to diversify their holdings and protect against price swings in public markets. It also gives them exposure to more companies than those available in the public markets.
How is private credit coping with the end of near-zero interest rates?
The vast majority of private credit loans have floating rates, so yields have surged since central banks jacked up borrowing costs. Some of the riskiest lending, advanced to the most struggling companies or to finance an acquisition, bankruptcy or a spin-off, has begun to generate annual percentage returns in the mid-teens. That kind of yield is on par with a lot of private equity investing, often for less risk. Those great returns can also be dangerous, because the borrowers are saddled with higher interest costs, and that could push some over the edge and cause them to default on their loans. One additional downside for investors from the surge in yields is that some private credit funds have been blasting through their “hurdle rates” – the level of returns at which a fund’s manager gets a share of the profits in addition to the management fee. Investors in private credit funds, known as limited partners, have been asking some managers to amend those terms to make the hurdles harder to meet.
What are the risks around private credit?
The lack of liquidity compared to public markets can lead to steep losses if an investor wants a quick exit. Some funds can lock invested capital away for more than five years, without a formal trading mechanism. Limited partners (LPs) can sell their positions on a nascent “secondaries” market, but usually at a substantial discount to the price they paid for the position. Lack of transparency is also a concern. Funds have fewer obligations than their publicly traded equivalents when it comes to disclosing their holdings and the performance of their investments. Because there is no market for these assets, they cannot easily be valued and their worth can be a matter of heated debate. Most funds say they value their assets on a quarterly basis, but this can vary. Third-party valuers may be used, but fund managers don’t have to take their advice in every situation. The industry’s continued connection to private equity, which keeps piling on leverage, means that if any shocks hit private equity, private credit is also likely to be affected.
Can private credit withstand a prolonged recession?
No one really knows. Private credit lenders argue that the loans they arrange are safer than many other forms of lending as the capital they use to fund them is locked in for longer, and underwriting standards are stronger. In a May report, the US Federal Reserve said it wasn’t worried about private credit, but that the lack of transparency makes it difficult to assess risks to the broader financial system. Moody’s has said increased competition between banks and private credit funds might encourage riskier debt deals, leading to more defaults. Uncertainty around the terms of private deals means it’s unclear how far valuations would fall in a recession. Investors could find it hard to sell positions in struggling funds. Fund managers wouldn’t even necessarily have to report when a borrower breaches the terms of their loan.
What are regulators doing?
The US Securities and Exchange Commission is forcing private funds to make quarterly reports and disclose more information on their expenses. There are signs that the UK’s Financial Conduct Authority will review the way valuations are decided in private markets. But overall, there are no widespread moves that would bring the regulation of private credit funds in line with that of deposit-taking institutions. In the meantime, many governments are happy to attract more private capital to finance types of lending that they see as too risky for banks. BLOOMBERG
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