For multiple reasons, the parabolic growth in private lending has caught the attention of specialty lenders, institutional investors, and even regulators. Let’s dive into what private credit is and why everyone is talking about it.
What is private credit?
Debt has different registration status depending on the borrower’s disclosures. Public registration requires stringent disclosures mandated by the SEC, while 144a securities, which can only be purchased by Qualified Institutional Buyers, require fewer. Private credit is debt that exists outside the public and 144a markets. It can go by many terms: direct lending, private debt, private capital.
Private debt tends to be floating rate, and terms are negotiated to meet the requirements of both the borrower and lender. Unlike the public domain, the lenders are non-bank entities, such as insurance companies, pension funds, family offices, sovereign wealth funds, and high net worth individuals. The borrowers tend to be below investment grade if rated at all, and small to medium sized enterprises with total revenue under $1 billion annually.
The following diagram compares private credit with other debt asset classes in terms of borrower size and risk.
Corporate Debt Market Instruments
The definition of private debt should also include warehouse financing, private securitizations, and whole loan acquisitions. As with the public securitization market, private securitizations add a layer of complexity due to complex structures and difficult-to-model assets.
Private credit should not be confused with private equity. Private credit has a focus on capital preservation. There is no benefit if a borrower outperforms expectations. The lender expects to receive their scheduled interest payments and principal once the loan matures or is refinanced barring a default. On the other hand, private equity involves an ownership stake in a company. Typically, the lender will have a management role in the company and is looking for upside potential. A private equity investment may only recoup their investment once they sell their stake in the company.
Growth factors and private market benefits
Below is a chart detailing the growth of the private market since 2000. Volume increased from $40 billion in 2000 to $1.73 trillion in 2023, according to BlackRock and Preqin. By 2028, Blackrock predicts that the market will reach $3.5 trillion. Lending growth has been driven by a few factors. After the Global Financial Crisis (2007-2009) banks tightened their underwriting considerably. Not only did banks need to increase their capital levels, but capital charges for riskier lending became more onerous. Additionally, fixed income investors faced an era of ultra-low rates. Alternative investments flourished during this time as yield-hungry lenders began scouring every corner of the market to meet their hurdles. The private market was a natural fit as many pension and insurance portfolio managers needed assets with longer durations to match their liabilities.
Private credit assets under management
The market offers benefits to both borrowers and lenders. For borrowers, the advantages are obvious: access to credit. These entities do not participate in the public market for a few reasons – namely their offering sizes would be too small, they tend to be lower rated or unrated, and highly levered entities. Funding options are somewhat limited.
Lenders have quite a few benefits: there is a yield and spread pickup compared to comparable public offerings, volume, and performance. Returns on private capital generally exceed the broadly syndicated loan market by 2-4%. Volume is also a key consideration for lenders.
Private market deals can be done with one lender or split between a handful of lenders (a ‘club deal’), allowing each to get a sizable portion. Finally, default performance has been extremely strong when compared to other high yield debt sectors. A fair counterpoint to performance is the track record. Though private credit has been around for about 30 years, its scale was much smaller than it is today and there has not been extensive reporting on defaults through a recession.
Year-to-Date Default Rate (As of Oct, 2023)
The cost of private credit
There is a cost to the private market – if it were easy and scalable, everyone would be originating deals. The costs of private debt include substantial operational overhead, illiquidity, an onerous origination model, and unknown future regulations.
Private debt operational overhead
Operationally, handling private debt can be a burden. There are no automated trade confirmations or settlement platforms; corporate actions need to manually be reviewed, signed, and booked; and day-to-day actions (entering floating rate indexes or booking amortization payments) need to be sourced and entered manually.
Many premier Investment Book of Record systems do not natively handle private assets, especially assets that need contract level detail. This leads many managers to buy additional systems and go through a painful system integration process. Adding to the complications, vendor data is usually non-existent for these assets.
Additionally, the hand-off from the front to back/middle office is not clean. With public and 144a investments, after purchase, the front office can pivot to the next deal. With privates, the front office needs to provide some information at purchase and through the life of the deal to facilitate clean and accurate analytics.
It’s common in the industry to call in specialized consultants to bridge these gaps —streamlining front-to-back-office workflows, ensuring accurate data capture, and reducing the operational burden. At Grandview Analytics, our team regularly steps in to address these pain points, helping investment managers meet the demands of private credit with precision and confidence, ensuring their operational framework supports strategic objectives without becoming a drain on resources.
Private market illiquidity
Given that private loan amounts are smaller and given to companies that are not widely tracked by credit research desks, liquidity is usually extremely limited. Lenders should expect to hold the debt until maturity or refinancing. An additional consideration is the lending environment when the debt matures. These smaller entities are currently relying on the private market to fund themselves. Refinancing debt during a market downturn could be prohibitively expensive or even impossible if conditions are restrictive.
Origination process
The origination process is considerably more difficult and almost entirely relationship based. Lenders will typically have a network of target borrowers that have been thoroughly screened. You need a deep network of bankers to make introductions to these prospective borrowers. The key to gaining scale is having industry contacts to participate in deals. The legal document review process is intense, and an in-house legal team will be a big help as well. Expect to spend quite a bit of time with them.
Private credit regulation
Regulation is also a developing story. When it was a rounding error in the total fixed income market and only limited to a handful of lenders, regulators did not focus on the market. However, given the recent growth, opacity in market values, and the interconnectedness of the borrowers and lenders, regulators will likely examine the space and determine if there is any systemic risk.
The future of private credit
Private credit has quickly evolved from a niche market into a central player in the global financial landscape, offering both borrowers and lenders a unique set of opportunities. For borrowers, it provides much-needed access to capital when other avenues may be closed. For lenders, it delivers higher yields and diversification, albeit with operational challenges and risks, such as illiquidity and the complexity of origination. As the market continues to grow and regulators begin to take notice, private credit is set to remain a crucial part of the financial ecosystem. However, investors must navigate its intricacies carefully to harness its potential while managing its inherent challenges.
At Grandview Analytics, we regularly help clients navigate operational challenges around private credit. From data management to asset lifecycle operating models, Grandview can streamline your operations. If you have comments or questions about your own private credit journey, feel free to reach out to Tony Celia directly.
