A new era for private credit – what does it mean for investors?

Key takeaways

• The shift of some longer-term lending from banks to asset managers, and investors’ search for yield, have spurred a rapid rise in private credit
• It can offer investors diversification, low volatility, and predictable and attractive risk-adjusted returns, especially in the current higher interest rate environment
• Slowing growth and floating-rate interest payments will put more private credit borrowers under pressure and could result in higher default rates on existing loans; but recovery rates have historically exceeded those for the equivalent-rated publicly traded bonds
• For investors with an appetite and tolerance for illiquid investments, private credit can be a valuable addition to a more traditional fixed income portfolio.

Demand for private credit – or non-bank loans to unlisted companies – has exploded amid rising interest rates, banks’ retreat from corporate lending and investors’ search for yield. We explore the rapid rise of a new asset class, the associated risks, and what it can offer investors.

The private credit market has been one of the fastest-growing areas of lending and a rapidly maturing asset class. It has more than doubled in size since 2015, and is now worth around USD 1.3 trillion, estimates Moody’s, roughly comparable to the size of the global high yield bond market.

What is private credit?

Private credit covers a broad spectrum of lending that is not issued or traded in an open market. Typically speaking, it comprises debt financing by non-bank institutions – including investment funds, private equity, and asset managers – to unlisted companies. The latter can be any size and anywhere on the risk spectrum, from investment grade to the lowest-rated high yield, though many lack official credit ratings. The bulk of private credit serves small to mid-cap companies seeking to fund buyouts, and the average loan duration is around 5-7 years, although in practice the loans are often repaid after 3-4 years as private equity owners sell the company or refinance the debt.

Why the sharp rise in such lending? Trends in corporate demand, banks’ risk appetite, investor demand for yield, and rising interest rates all play a part. Take the first: many companies are not a good fit for the ‘traditional’ financing markets. They may be too large for bilateral bank lending. Conversely, they may be too small or lack a credit rating for the more liquid credit markets (including broadly syndicated loans and high yield bonds). Conditions in these markets may not favour new issuance, as was the case for much of 2022. The company’s business model may be complex, or they may not want to share such information widely. Many companies, or their private equity owners, are happy to pay a premium to design a bespoke and flexible debt structuring with one or a small club of specialist lenders, to get a quick decision on financing, and a loan that is not subject to the prevailing market sentiment.

Banks retreat, alternative managers advance

At the same time, banks have been retreating from ‘riskier’ corporate lending, driven by more onerous capital rules imposed after the 2007-2008 global financial crisis. Recently announced proposals for new capital rules in the US could potentially exacerbate this trend. Both mainstream and alternative asset managers are increasingly stepping into the breach. This year, private credit has offered a welcome diversification of private equity’s business model in a tough environment for deal-making and corporate listings. There are even some synergies, given the focus on assessing a firm’s viability and weaknesses, and due diligence on a potential target can sometimes be reused.

In it for the long haul

For investors, private credit offers a yield advantage over equivalent-rated corporate bonds, in part to compensate for its illiquidity. Crucially, in recent years it has allowed them to benefit from rising interest rates, since such loans typically employ floating rates. Because private credit loans are usually only marked to market quarterly, price volatility is low. Loan-to-value rates for direct lending are generally less than 40-50%. Returns are not correlated to bond market movements and market sentiment, offering a potential source of portfolio diversification and stability. In addition to coupons, investors can also benefit from upfront structuring fees and additional payments if the company decides to repay the loan early.

Private credit’s multi-year nature suits long-term investors such as pension funds, insurers, and sovereign wealth funds, who value its high and stable returns (typically 8-10% net annual returns after management fees, and higher for leveraged private credit funds) over liquidity. An April 2023 Blackrock survey of institutional investors found more than half plan to increase private credit allocations. Niche private credit strategies are also growing, including deals where interest rates reset lower if the borrower meets pre-defined sustainability targets.

Of course, an environment of higher interest rates and deteriorating growth will be a drag on corporate free cash flows and should be a concern for all equity and credit investors. Demand for private credit has slowed recently. European private credit deals dipped in the second quarter of 2023 to their lowest quarterly rate since 2020, notes consultancy Deloitte. Company defaults will undoubtedly rise; Moody’s expects the default rate on high yield bonds to peak at 4.7% in the first quarter of 2024. Yet with stricter contract terms and a higher likelihood of finding solutions in a bilateral contract, we assume a lower default rate than for the equivalent rated public credit, and a higher recovery rate of assets for the creditor. Historically, recovery rates for private loans have been much higher than for high yield bonds. Private credit is typically senior secured, giving lenders first claim on the company assets, and putting them in a powerful position when it comes to negotiating a restructuring.