The private credit market has doubled in the last four years as investors poured capital into the market and borrowers sought new ways to leverage the advantages of private capital.
What is Private Credit?
Private Credit is a diverse market of individual loans provided to borrowers from non-bank lenders. Like its sister market private equity, the terms of private lending are directly negotiated with an individual company. As such, borrowing in the private market – unlike tradeable bonds in the corporate or high-yield markets – is often done with more flexible terms and the ongoing support of the lender.
While private credit is typically more expensive than public bank loans or money raised in the public bond markets, private borrowers have increasingly appreciated the availability of capital and the opportunity to remain private for longer.
The combination of attractive yields and attractive borrowing terms have made private credit the fastest growing segment of the credit universe since the Global Financial Crisis. In 2010 the total market was relatively small, at near $250 billion. But the market has grown steadily and in just the last four years, the amount of privately issued debt has doubled, from $725bn in 2018 to $1.5 trillion in 2022, according to Preqin, a data provider specializing in alternative investments. The asset class now rivals the size of the entire US high-yield bond market and exceeds the well-established $1.4 trillion leveraged loan market.
Why Has the Private Credit Market Grown So Rapidly?
Returns in the private credit market have been attractive, averaging 9% a year over the last decade, according to alternative investment advisor Cliffwater. But the real driver of growth has been more structural, driven by a slow and steady evolution in how companies are being financed.
When banks were forced to step back from more aggressive lending after the Global Financial Crisis (circa 2008-2010), private, non-bank, firms stepped up. As that crisis faded, an unprecedented era of low interest rates set in. This so-called cheap money not only fueled demand from companies for new and more aggressive borrowing but also significant demand from investors seeking more yield than the traditional bond or leveraged-loan markets could provide.
By the time COVID-19 again stunned the financial system, the beneﬁts offered by private financing were both better understood and more appreciated. So, when banks, one decade later, stepped back as COVID-19 brought large swaths of the economy to a halt, private lending again stepped up.
More recently, rising interest rates once again threatened the stability of the financial system. The collapse of Silicon Valley Bank and the forced sale of Credit Suisse confirmed how fragile the system could be. Unsurprisingly, banks stepped back from company lending and private lenders once again stepped up. Only this time they were more prepared, having broadened their own sources of capital and were more ready to lend in size. Reportedly, when Finastra, a financial software company, recently sought to refinance its $4.8 billion loan from Morgan Stanley, the company turned to private credit firms. The result was the largest private loan ever recorded.
Demand is Likely to Remain Robust
While the U.S. Federal is understood to be near the end of its tightening cycle, the market expects interest rates will remain higher for longer and financial conditions will remain restrictive. This is likely to keep bank lending limited and encourage companies to look to private-credit funds for refinancing or additional capital.
Meanwhile, interest in owning private credit has broadened to institutional investors, including public pension funds, endowments, and foundations as they seek alternative sources of both income and diversity within their broader portfolios. Even insurance companies, who typically need investment-grade exposure, have been able to access the private credit market through asset-backed lending.
For example, late last year, alternative asset management company Apollo raised $1.8 billion for music-publishing company Concord. Because the debt is backed by royalties from over a million songs – including stars such as Little Richard, Daft Punk, and Pink Floyd – the notes received an A+ rating from Kroll Bond Rating Agency, allowing participation from a wider variety of institutional investors and insurance companies.
Can Returns be Sustained in a Weaker Economy?
Because the private credit market is relatively new, there is no historical guide to how it might perform in the current environment of high interest rates and slowing economic growth. The former is particularly relevant given that a lot of lending was done with floating-rate coupons, increasing the borrowers’ debt-servicing costs as interest rates rose.
Bank of America recently suggested the default rate on private credit could accelerate to 5% in 2024. While this number may sound high, rating agency Moody’s recently forecast U.S. High Yield bond defaults to peak at 5.6% in January of 2024 before slowing to 4.6% by August. That is, private credit is not forecast to be more vulnerable than other leveraged or sub-investment grade borrowing in the current environment.
Additionally, some view the private credit market as better situated than traditional corporate bond debt due to the prevalence of both distressed and special-situations lending which can be classified as countercyclical holdings – investments which perform relatively better when the economic cycle is weak.
Finally, the unique nature of the lender/borrower relationship in private credit transactions may prove to be supportive in an extended economic downturn. In a typical private transaction, a company expecting difficulty in making interest payments has only to reach out to their single (private credit) lender to discuss modification of the loan’s terms. In contrast, a company that financed itself through the public bond markets faces such a large pool of creditors that modification is rarely attempted.
One could look back at the last decade as a series of anomalous and unrelated reductions in bank lending. But private credit has its advantages, for both borrowers and lenders, and thus it looks more likely that private credit will continue to grow and evolve. Particularly in the sub-investment-grade market, companies may well see the confidentiality, simplicity, and availability of funds from private lenders across the economic cycle to be preferable to the terms offered by traditional banks.
Meanwhile, institutional investors seeking higher yields, and returns less correlated to either interest rates or equity markets, are likely to continue to provide capital while the growth in fund vehicles and other more innovative structures should open broaden the market to the largest pool of capital: individual retail investors.
Nevertheless, we encourage our readers to do more of their own research. We strongly encourage you to use the information we have provided above only as incremental information about this market sector, and the above should in no way be construed as financial advice.