Private Credit
Discover what private credit is, how it works, and its growing role in non-bank financing.
What Is Private Credit?
Private credit refers to the privately arranged loans between non-bank lenders and borrowers. Additionally, credit refers to a contract, most frequently a loan, that a borrower must repay to their lender with interest.
Non-bank entities, like business development companies (BDCs) or private credit funds, typically create these debt instruments. They are not publicly traded.
Historically, private credit has been issued to middle-market companies with annual revenues between $10m and $1bn.
In recent years, the market has grown significantly. Companies usually utilizing leveraged loans have turned to private credit for funding.
- Private credit refers to loans and financing issued in a non-public market.
- Compared to private equity, private credit has more predictable returns and benefits from higher interest rates.
- Borrowers/businesses with higher risk profiles may seek financing from the private market if they are unable to secure financing from banks and thus turn to credit funds.
- Institutional investors and asset management firms are the major private credit fund investors.
Why Has Private Credit Grown?
Private credit started in the 1980s, surged after the 2008 Crisis, and has grown again in the 2020s.
In early 2022, interest rates were rapidly increased in response to the pandemic's economic impact and geopolitical issues. Thus, banks issued significant amounts of outstanding loans that became less profitable.
Private credit funds saw a profitable opportunity. Banks were unwilling to issue new loans to borrowers seeking financing, leaving a gap for the funds to fill.
Private credit funds experienced increased investor demand as a result of the heightened interest rates over the last few years.
The 2008 global financial crisis also drove the private market’s growth. After the crisis, it became harder for companies to get bank financing, as banks became hesitant and risk-averse when issuing loans.
Heightened interest rates have increased the profitability of private credit, especially for loans with floating rates, because they reflect changes in market rates, which have increased steadily since 2022.
Excluding real estate, private credit holds $1.6tn. It is projected to reach $2.7tn by 2027.
In response to the competition PC funds have generated, banks have started to offer cheaper borrowing deals and have reduced their required covenants.
Some major banks, such as J.P. Morgan and Société Générale, have launched their private credit funds and now offer private credit advisory.
Advantages of Private Credit for Borrowers
Borrowers benefit from more access to capital, flexibility in financing, and relationship-driven financing.
The advantages are the following:
- Increased flexibility and access to capital: Alternative financing offers borrowers increased flexibility and access to capital. While it may be difficult for some businesses to secure traditional loans from banks, private credit funds may be open to offering loans.
- Flexible loan terms: Loan terms tend to be more flexible, and the turnaround time from submitting an application for debt to subsequently securing approval is faster.
- Relationship-driven financing approach: Securing financing from private credit funds is often relationship-driven. Thus, the borrower has an advantage. They have access to the lender's expertise in managing and growing businesses.
Advantages of Private Credit for Investors
Investors have many advantages. These include high returns and diversification. They also include the chance for capital growth and regular fixed income.
Some of the advantages are:
- High returns: Private lenders can charge higher interest rates than traditional lenders. These loans are also often backed by collateral and generate higher returns.
- Diversification: Private financing diversifies portfolios. This is useful for those heavy in public equities or fixed-income.
- Market resilience: These debt investments tend to be resilient throughout the market cycle, including periods of high economic growth, downturns, and recovery.
- Potential Capital Appreciation: Private credit investments can grow in value in addition to providing income. Capital appreciation can occur if the underlying borrower's creditworthiness improves or the loan is sold at a premium.
- Regular Income Stream: Many private debt investments provide regular interest payments, generating a steady income stream similar to that of other fixed-income investment instruments, such as bonds.
- Exclusive Investment Opportunities: These funds generate access to investment opportunities that are absent in the public markets. This can include loans to smaller businesses, emerging industries, or specific asset classes.
Risks For Investors
Investors face risks related to the market, liquidity, and credit. Private credit investments are less liquid than public securities, which means they cannot be easily traded on the secondary market.
Investors may have to hold the investment until the loan matures. Alternatively, they may have to find a buyer, which depends on the borrower and market outlook. Some risks include:
- Credit Risk: Borrowers tend to be riskier than borrowers in the public bond market. Their creditworthiness may be lower, or they may operate in industries more susceptible to economic downturns. These factors increase the chance of defaults, leading to significant losses for investors.
- Market Transparency: The private credit market is less transparent than the public bond market. Information about borrowers and loan terms can be limited, making it difficult for investors to assess the risks involved fully, as funds have fewer disclosure requirements.
- Fees and Expenses: PC funds often charge management fees and other expenses that can reduce investors' final returns. These fees can be higher than those associated with traditional bond funds.
- Concentration Risk: Some funds focus on a particular industry or borrower type. A long-term downturn in that sector can significantly impact the fund's performance.
Note
The J-Curve Effect describes when a fund might initially have losses as it invests new capital. Upfront fees and expenses can outweigh initial returns on the investments. Time may be required until a positive return is seen.
Risks for borrowers
Borrowers who choose private credit over traditional financing face potential risks. These include high interest rates, tough loan terms, difficult exits, and loss of equity.
Some of the risks are:
- Higher Interest Rates: To compensate for the risk of lending to borrowers who may not qualify for traditional loans offered by banks, borrowers likely need to pay a higher interest rate to private lenders.
- Stricter Covenants: Loan agreements may contain stricter covenants, which restrict the borrower's financial activities and may reduce the borrower's flexibility in managing their business.
- Shorter Loan Terms: PC funds sometimes require shorter repayment terms compared to traditional bank loans. This could pressure the borrower's cash flow, especially with larger loans.
- Potential for Equity Loss: In some cases, private lenders might require a form of an equity stake in the borrower's business as collateral. This means the borrower could potentially lose a portion of ownership and, thus, future profits.
- Exits: Exiting these loans can be harder than exiting traditional loans. The borrower may have limited options for refinancing or selling the debt to another lender.
Conventional Fixed Income vs Private Credit
The following table from KKR highlights the differences between traditional fixed-income and private credit:
| Fixed income | Private credit | |
|---|---|---|
| Market type | Publicly syndicated and sold | Privately originated and held |
| Exchange traded | Yes | No |
| Coupon payments | Yes | Yes |
| Coupon structure | Usually fixed rate | Usually floating rate |
| Credit rating | Rated | Not rated |
| Call protection | Varies | Yes |
| Liquid? | Yes | No |
| Valuation | Frequent | Infrequent |
Types of private credit
Different types of private credit include direct lending, distressed debt, venture debt, mezzanine financing, and special situation debt offering.
- Direct lending: Non-bank lenders, either alone or within a small group, lend to companies. These loans are typically held to maturity.
- Distressed debt: Funds invest in debt trading below the original value with the aim of generating a profit when the company in debt liquidates or restructures. Sometimes, new financing is given to the company in or near distress.
- Venture debt: It is provided to start-ups, including those that may not yet be profitable, based on various factors such as their growth prospects and revenue. Typically, loans are issued based on the firm’s current recurring revenue.
- Mezzanine finance: Mezzanine finance involves investing in higher-risk debt that sits between senior debt and equity in the capital structure, providing additional capital to the company.
- Special situation: Special situation investing involves private credit funds issuing loans to generate returns from specific events. While unique circumstances may influence lending decisions, they often consider company fundamentals as well.
Private Credit Deals & Fundraising in 2023
Key deals and fundraises from 2023 are described below:
- Blue Owl and Oak Hill led the $5.3bn debt funding for Vista Equity Partner’s refinancing of Finastra, a fintech company, in August 2023.
- Apollo aims to lend over $4 billion in NAV loans to private equity firms currently struggling to raise capital.
- Qualitas, an Australian alternative real estate asset manager, secured $483m in debt.
- Sixth Street provided the $310m in debt financing to HireVue (a Carlyle portfolio company) for its acquisition of Modern Hire.
- Oaktree seeks to raise over $18bn to create a recording-breaking private credit fund.
- Blackstone Inc. has raised $7.1bn for the largest energy transition private credit fund.
Private Credit FAQs
Direct lending is currently the biggest part of the private credit asset class.
This alternative asset class usually attracts institutional investors and asset managers. Funds may also have minimum investment requirements and regulations restricting retail investor participation. Institutional investors include endowments, pension funds, and insurance companies. Hedge funds can also participate in private credit investing.
In contrast to private credit funds, private equity funds purchase an ownership stake in a company as an investment. Their ultimate goal is to sell their stake or exit their position at a higher exit multiple than at initial entry.
Private equity is considered riskier due to the nature of equity, but it also comes with a theoretically unlimited upside. Returns on debt investments are easier to predict.
Both investment forms are conducted in the private market, usually only available to institutional investors and sometimes high-net-worth individuals.
Second-lien debt, Mezzanine debt, and preferred equity are collectively referred to as “junior capital.” In the case of default, these capital investments are not secured by assets and rank below more senior debt.
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