What is private credit and why has the growth of this particular market been so spectacular? Looking back at the lending market as a whole, first there were the banks, then debt specialists and private equity entered the lending market, quickly followed by hedge funds and wealth managers. The private credit market really began to make its mark after the 2007 – 2009 Global Financial Crisis, when banks tightened their belts and pulled back from lending. Today, not only on Wall Street in the United States, but in all major financial centres, the buzz word on everyone’s lips from venture capitalists to sovereign wealth funds is private credit.
An explanation as to what private credit represents is where SMEs (small and medium-sized enterprises) who are non-investment grade and typically represent the recipients of loans from non-bank lenders. This market can serve as a diversifier as debt is less correlated to equity markets, and due to periodic income from repayments the J-curve is smaller*.
*J-curve – is a trendline that shows an initial loss followed by a dramatic gain, hence the j-curve.
In a nutshell private credit targets non-investment grade SMEs, and unlike private equity there is no direct management involvement. Any added value will come mostly from restructuring. The type of investments are usually direct loans which relate to senior instruments in the capital structure, often accompanied with bespoke terms and floating-rate coupons**.However, it must be pointed out that as the market has expanded so have the catchment levels, with the market catering to a more diverse base.
**Floating-Rate Coupons – A floating rate note, commonly referred to as a FRN, is a debt instrument with a variable interest rate or coupon which is tied to a benchmark rate such as Libor (London Interbank Offered Rate) which of course has now been replaced in the US Dollar market by SOFR, (The Secured Overnight Financing Rate) and in the GBP market by Sonia, (Sterling Overnight Index Average). Many FRN’s have coupons that pay quarterly, and investors can benefit from increasing interest rates as the note adjusts periodically to current market rates.
The private credit boom has recently been driven by central banks monetary tightening policies which began in 2022 with unprecedented rate hikes over the next year to late 2023. The Federal Reserve raised interest rates ten times over in this period from a low of 0.25% to a high of 5.25%. Similarly in the United Kingdom, the Bank of England increased its key benchmark rate eleven times from a low of 0.25% to a high of 5.25%, and in Europe the ECB (European Central Bank) raised its rates seven times from a low of 0% to a high of 3.75%.
This has inevitably forced borrowers to look elsewhere to look for alternative lending sources, and the private credit market has benefited considerabley. Indeed, earlier this year in the United States, a number of mid-cap banks ran into liquidity problems, and this together with higher interest rates prompted some the more traditional lenders to exit certain business lines or unload assets. Hence, the retreat of bank lending, higher interest rates and bigger fees have brought a large number of new players to the private credit market, which has turned from what was essentially a niche market to a must-have market.
Today the private credit market has expanded its philosophy to what has been described as a catch-all concept. Indeed, the market now incorporates traditional direct lending to the SMEs to finance buyouts, real estate and infrastructure debt. Experts advise that this will help fund managers to profit from strategies which can shield them from the volatility of mark-to market* losses in public markets. The expansion can be seen by the number of new players entering the market, such as large asset managers who are bolting on private market funds to their existing businesses or in the private equity world increasingly using private market companies for their acquisitions. Indeed, the risk strategies employed by the new entrant private credit funds differ massively from one company to another. For example, some companies are offering high-risk mezzanine finance* to companies that are struggling, whilst mid-sized companies with fairly small or low leverage are being offered senior secured debt and private equity are being provided with funding for buy-out transactions.
*Mark-to-Market – is an accounting practice whereby the value of an asset is adjusted to reflect its true value in changing market conditions. Furthermore, it is also where assets and liabilities are recorded at their current market value, and if a company had to pay off all their debts and liquidate their assets, mark-to-market accounting would provide an accurate value of what the company is worth at that time.
**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.
Mezzanine financing is a type of junior debt or capital and is viewed as the last stop on the debt borrowing chain or capital structure, before equity is sold in order to raise capital. Mezzanine financing allows companies to access capital beyond that of what can be accessed through senior debt. It is typically longer-term debt (7 – 8) years, and is interest only during the loan period, with amortisation at maturity. Many borrowers view mezzanine finance as “solution based” capital as opposed to permanent capital, serving a specific purpose(s), which can be replaced with lower interest-bearing capital such as senior debt at a later date.
The private credit market has increased by circa 300% in size over the last nine years, with experts valuing the market in the region of USD1.5 Trillion. Indeed, one of the largest alternative credit managers has advised that the industry could grow to the stage where it has replaced USD 40 Trillion of the debt markets. The private credit market began its life by catering to the private equity companies, and like the private equity companies they raise funds from investors. This however is where the similarity ends, as private credit lends debt to their clients whereas private equity as the name suggest invests equity in their clients.
Experts within the private credit market are referring to this boom as “debanking”, which according to one senior player is still in its infancy, while others refer to the current state of the private credit market as “The Golden Moment”. Both analysts and experts suggest that new banking regulations in the United States under proposed Federal Reserve rules will act as a catalyst for the private credit market, as the capital required to support the US wholesale banking industry could increase by as much as 35%.
However, there are some dissenters from the regulatory arena in the United States who say that the private credit market could prove a risk to the US banking system as, unlike the banking industry, it is subject to indirect and somewhat minimal oversight. Indeed, the Federal Reserve has been requested by lawmakers as to what they, the FDIC (Federal Deposit Insurance Corp), and the Office of Comptroller of Currency were doing to address this issue. However, in a counter statement the American Investment Council trade group advised that private credit services were noy systemically risky and were quoted as saying, “ In this economy, private credit is helping small businesses to get capital to grow and succeed”.
Naysayers and detractors who say the market has grown to a point where there will be failures should not be ignored. Whatever the market, history has shown that there is always a crisis waiting around the corner. The Global Financial Crisis stands out as a case in point as does the mid-cap banking wobble in the United States earlier this year which spread to Europe and led to the downfall of the eminent Swiss bank, Credit Suisse AG.
New entrants to the market are committing funds in the region of USD500 Million to USD1.5 Billion, despite the fact that some analysts are predicting that the market itself is coming under strain from rate hikes inflicted on economies through central bank quantitative tightening policies. Experts advise that most of the private credit investments that are outstanding as of today would have been contractually agreed eighteen months ago and would have been made against a completely different economic backdrop.
Most private credit loans are arranged (as stated previously) on a floating rate basis, and the interest hikes over the last year could potentially have a significant effect on the performance of those companies and the funds invested therein. One expert suggests or rather confirms that the whole structure is now coming under strain. Many balance sheets of debtor companies have five to seven turns of leverage and if they had to be refinanced today then every dollar earned would go on interest payments.
Many players in the private credit market have only experienced bullish tendencies; they have never experienced a bear market or a downturn. Recently released data shows that to date in 2023 the volume of defaults in the direct-lending market in the United States alone reached circa USD1.7 Billion. Indeed, some of the savvier participants are already hiring those with expertise in workout and restructuring including expertise in managing investments in a downturn. Market sentiment and data suggest interest rates are set to fall in 2024 – they can’t come soon enough for many in the private credit market.