Private Credit: A Growing Alternative Market Post-Financial Crisis
Since the global financial crisis, the private credit market has grown, diversifying funding sources beyond banks and public debt. It’s expected to continue expanding due to increasing borrower demand. Private credit, negotiated directly between borrower and lender (typically a large asset manager), is a part of the $12 trillion alternatives market. The main category is direct lending, involving negotiated loans to small and mid-sized firms in growth phases. These firms seek financing but aren’t ready for public markets. Globally, private credit (excluding real estate) totals around $1.6 trillion in assets under management as of March 2023, rivalling U.S. high yield bond and leveraged loan indices. Factors driving growth include borrower preference for pricing certainty, customised funding, and smaller deals. Public markets cater to larger borrowers, with average deal sizes well above $700 million in the high yield market and about $480 million in the leveraged loan market since 2020.
This is impractical for small to mid-size firms. Private credit, totalling about $698 billion in North America, presents an opportunity for borrowers to diversify financing as bank lending becomes less attractive. Private credit funds are typically low-leverage with long-term capital commitments from investors aligning with loan maturities. Losses are borne solely by investors. Structurally higher demand for private credit is likely to expand the market for potential borrowers and increase lending rates, leading to wider spreads between private and public credit markets. This supports our strategic preference for this asset class, but private markets are complex and may not suit all investors. Private credit is not immune to economic challenges, requiring increased selectivity and consideration of how much of the opportunity and risks are priced in.
Private Credit: Favorable Risk-Reward Profile and Yield Premiums
In the realm of private credit, historical data has shown consistently low loss rates. It is anticipated, however, that a return to normalcy may be on the horizon, owing to higher financing costs and decreased activity. This trend has already affected borrowers in the public markets, particularly those with floating rate debt. With the influx of new private credit lenders, a discerning approach is deemed crucial. Selecting sectors and borrowers adept at navigating a higher cost of capital is paramount, as is rigorous due diligence on deal terms and lending standards. Over extended periods, loss rates in private credit have either matched or been lower than those in public markets like U.S. high yield and leveraged loans, as indicated by the Cliffwater Direct Lending Index (CDLI) for North American direct lending. The structural attributes of private credit, including meticulous credit selection and enduring lender partnerships, contribute to these similar or lower loss rates. Seniority in the capital structure further fortifies this position.
Despite comparable or lower loss rates, private credit has consistently offered a significant yield premium compared to public markets. Over the past few decades, average yields have exceeded comparable public market peers by approximately 400 basis points or more, particularly in major U.S. high yield and leveraged loan indexes. It is anticipated that this yield gap will widen due to heightened borrower demand. A portion of this excess yield can be attributed to a “middle market” premium, which compensates lenders for extending financing to small- or mid-sized companies that may struggle to access public markets. It also reflects compensation for assuming illiquidity risk. Unlike public market exposures, private credit lacks easy tradability, and early sales may incur capital losses, rendering it unsuitable for all investors. It is a long-term investment suited for those with the capacity to fulfil their liquidity needs from other parts of their portfolio. However, for investors with adequate liquidity management, private credit presents potential opportunities to capture this premium. Continual borrower demand, augmented pricing power, seniority in the capital structure, and comparable or lower loss rates relative to public peers collectively position private credit favourably for individuals considering long-term investment horizons.
BlackRock, A fast-changing U.S. financial landscape:
BlackRock, Struggling Corporate Borrowers Turn to Private Credit to Defer Interest:
Financial Times, Private credit funds step in for companies facing mountains of debt: