The Continuing March Upwards of Private Credit
Private credit can trace its roots back to the 1980’s where companies with strong credit/borrowing records were being loaned funds directly from insurance companies. However, post the 2007 – 2009 Global Financial Crisis, private credit really came into its own as an alternative to bank lending, especially as financial regulators were cracking down on those deposit taking institutions who were involved in risky lending. In today’s market, private credit has become a major contender in the loans market, and a serious rival to banks and similar lending institutions.
As of June 2023, data released shows that global closed-end private debt funds* have assets under management of circa USD1.7 Trillion, whereas as of close of business December 2015 global assets under management were circa USD500 Billion. Indeed, expert money managers suggest that by 2028, due to possible massive shifts in the financial markets, borrowers would flock to the front door of private credit funds, boosting the value of the global private debt market to USD3.5 Trillion.
Closed-End Fund – This fund is a type of mutual fund, and in order to raise capital or investment, the fund issues a fixed number of shares through a one-time initial public offering (IPO). The shares can be bought and sold on a stock exchange if the fund is quoted, but no new money can be received into the fund once the IPO closes. Access to closed-end funds is only available during a New Fund Offer (NFO).
Open-End Fund – As opposed to a closed-end fund, the open-end fund such as mutual funds and exchange-traded funds (ETF’s) accept new capital on a constant basis and also issue new shares.
Mutual Fund – This is an investment opportunity where monies/investments are received from a wide range of individuals and pooled together in order to purchase a wide range of stocks, bonds and other securities. Funds are managed by professional money managers and are structured to match the prospectus where the investment objectives are stated.
Private credit is responsible for providing a vast amount of financial resources into a number of differing investment strategies, some of which are outlined below.
1. Mezzanine Finance – Mezzanine loans or capital can be structured either as subordinated debt or as equity which is usually in the form of preferred stock. Mezzanine financing is recognised as a capital resource which can often be seen as subordinated debt and sits between higher risk equity and less risky senior debt. To facilitate the explanation of mezzanine debt, below are the definitions of senior debt and subordinated debt.
· Senior Debt – often issued in the form of senior notes and also known as a senior loan, is a debt that will be paid first by the borrowing company. In other words, it takes priority over other unsecured debt and in the event the borrowing company goes into liquidation, owners of senior debt will be the first to be repaid.
· Subordinated Debt – or as the name implies junior debt, is usually the last type of debt to be repaid. It has a lower status to senior debt and hence the name subordinated debt. Typically, subordinated debt or loans will carry a lower credit rating and will therefore offer a higher return than senior debt.
2. Venture Debt – Venture debt, sometimes referred to as venture lending, is a certain type of debt lending to venture-backed companies. A venture-backed company that receives venture debt is defined as companies who are at the start-up stage of their existence and rely on venture capital to expand their business. Typically the company has yet to make a profit, and loan size is usually based on the company’s recurring revenue
3. Distressed Debt – Private credit funds are known a). for buying up corporate debt that is currently trading well under its original value and b). where companies are in difficulties to provide new financing, with a view to make a profit when the company either liquidates or restructures.
4. Direct Lending – This type of lending by private credit funds, (aka unitranche loans), are typically a senior term loan (first lien and the least) but can also involve credit lines and second lien loans which are subordinated to the first lien.
5. Special Situations – As the subject suggests, loans in this case are applicable when a special situation or event occurs, and the company’s profitability or growth (a company’s metrics) are not taken into account when lending decisions are made.
A number of experts have asked the question: will private credit stand a sustained protracted recession? Private credit fund managers have answered that in many cases their loans are safer as they are locked in for longer than your standard lending institutions. However, the uncertainty that surrounds the terms in the private credit market means that in a recession no one really knows how far valuations would fall, and as a result would investors in funds that are struggling be able to sell out their positions.
Regulators in the United States, the United Kingdom and the European Union are looking at expanding regulation in the private credit market. Indeed, regulators in the EU are putting strictures in place which ensure that private credit funds will diversify risk, and will cap leverage, whereby funds use borrowed funds to enhance profits. However, it appears that regulation will remain somewhat opaque as there seems to be a lack of appetite to bring regulation in line with banks and other lending institutions. This of course may reflect the attitudes of many governments, who seem happy to encourage private credit investment that they deem too risky for banks.
