5 Things You Didn’t Know About Private Credit
Introduction:
Private credit, an alternative form of debt financing, has been making waves in the investment world. With banks becoming more conservative in their lending practices, private credit has stepped in to fill the void. Recent developments highlight the growing importance of private credit, particularly in the case of South Korea’s sovereign wealth fund, Korea Investment Corporation (KIC). KIC, which manages $169 billion, has been making significant bets on private credit and other alternative assets to reduce portfolio volatility.
Here are five things you didn’t know about private credit that highlight its importance and the opportunities it presents!
A Burgeoning Market:
Private credit has experienced exponential growth, especially since the 2008 financial crisis. With traditional banks tightening lending criteria, companies have turned to alternative sources for financing. The private credit market now stands at an astounding $1.2 trillion. This growth is not just a blip; it represents a fundamental shift in how companies access capital. (See Figure 1). According to PwC, by 2025, private credit in Europe is expected to be largely fund-driven, not bank-driven, indicating a continuing growth trend [1]
Diversity in Investment Strategies:
The private credit market is vast and varied, with each opportunity being unique in its attributes. As banks have withdrawn from financing a broad range of asset classes due to more stringent capital requirements, the private credit market has risen to prominence, providing a new suite of options, from private corporate debt to infrastructure debt and commercial real estate debt, among others. This has been especially beneficial for institutional investors who seek a less correlated and more secure income stream1.
Direct lending has been a significant contributor to the growth of private credit since the global financial crisis. This form of lending involves providing secured loans, typically backed by cash flows, to middle-market sub-investment-grade borrowers. As of now, direct lending is the largest sub-segment of private credit by assets under management.
Beyond direct lending, investors have the potential to create portfolios of multiple underlying sub-asset classes within private credit, thus achieving a truly customized and diversified portfolio. For instance, investors can combine private direct lending with real estate debt and infrastructure debt for sub-asset diversification. Additionally, underlying borrower diversification can be employed to ensure that losses are not amplified throughout the portfolio.
Finally, with the rapid expansion of investment options within the private credit market in recent years, the proposition of enhanced return with strong downside protection and low loss ratios has appealed to many investors. The key challenge is accessing the right segments of the private credit market at the right times and with the right risk profile. A portfolio diversified through private credit’s cash flow streams, supported by non-correlated underlying collateral, is considered highly efficient and productive in making use of this growing and complex asset class!
A Shield in Times of Turbulence:
Private credit has historically demonstrated resilience in times of market volatility. With deep access to company records, private lenders can conduct stronger due diligence than is often possible in public markets. Additionally, private credit typically involves a single lender, which can lead to more efficient resolutions in case of default. This resilience makes private credit an attractive option for investors seeking stability in uncertain times. (See Figure 2). According to Reuters, the Private Credit Default Index showed a default rate of 1.56% on U.S. dollar-denominated deals in the third quarter of 2022, showcasing its relative stability during economic fluctuations[2].
The Allure of the Illiquidity Premium:
Investing in private credit often comes with an “illiquidity premium.” Since private credit investments are not as easily traded as public bonds, they tend to offer higher yields to compensate investors for the lack of liquidity. This premium can be particularly attractive for investors who are willing to have their capital locked in for longer periods. As central banks have been increasing interest rates, this can have an effect on private credit markets. Standard & Poor’s points out that rising interest rates can have implications for U.S. corporate credit quality, which is an essential factor to consider when investing in private credit[3].
Personalized and Tailored Solutions:
Unlike public bonds, which are typically standardized, private credit deals are negotiated directly between the borrower and the lender, affording a high degree of customization in the loan terms. This customization is akin to having a suit meticulously tailored to one’s measurements, ensuring an impeccable fit.
For borrowers, this customization is invaluable as it grants them the flexibility to secure financing that is precisely aligned with their specific needs and objectives. For instance, a borrower could negotiate for a grace period before repayment begins, or structure the loan repayment schedule according to their projected cash flows. This ensures that the financing is congruent with their business model and growth plans.
For investors, the customization in private credit deals allows them to craft investment structures that sync with their investment criteria, risk appetite, and return objectives. Investors can, for example, negotiate interest rates, covenants, collateral requirements, and other terms that are reflective of the risk they are willing to assume. They may also seek specific rights such as board representation or warrants, which can provide additional upside.
Moreover, the direct nature of the negotiations can foster stronger relationships between borrowers and lenders, facilitating better communication and understanding. This can be particularly beneficial during economic downturns, where the private nature of the market and the established relationships may enable more nimble and cooperative responses. For instance, lenders might be more amenable to extending loan maturities or renegotiating terms to help a company weather a downturn, which, in turn, can protect the lender’s investment.
In summary, the customization options available in private credit deals, both for borrowers and investors, provide a level of precision and flexibility that is unmatched in public bond markets. This is not only advantageous in aligning financing with specific needs and investment criteria but also in fostering resilience during economic challenges.
Conclusion:
Private credit is more than just an alternative to traditional bank loans; it’s a dynamic and diverse field that offers unique opportunities for both borrowers and investors. With its exponential growth, resilience during market turbulence, diverse investment strategies, and customizable nature, private credit is poised to continue playing a significant role in the global financial landscape. As The Economist observes, the boom in private credit is not an isolated phenomenon but part of a broader shift in the financial landscape[4].
Whether you’re an investor looking for diversification and higher yields or a company seeking flexible financing options, private credit offers a plethora of opportunities. You can join our Private Credit Telegram Group to find out how you can diversify and get higher yields on your investment portfolio by clicking the link below:
References:
- PwC. (n.d.). Prime time for private markets: Private credit. Retrieved from https://www.pwc.com/us/en/industries/asset-wealth-management/library/private-credit.html
- Reuters. (2022, December 20). Analysis: Private debt markets face reality check as companies grapple with rising rates, recession. Retrieved from https://www.reuters.com/business/private-debt-markets-face-reality-check-companies-grapple-with-rising-rates-2022-12-20/
- Standard & Poor’s. (2022). Credit FAQ: What rising interest rates could mean for U.S. corporate credit quality. Retrieved from https://www.spglobal.com/ratings/en/research/articles/220307-credit-faq-what-rising-interest-rates-could-mean-for-u-s-corporate-credit-quality-12203258
- The Economist. (2022). The private-credit boom. Retrieved from https://www.economist.com/finance-and-economics/2022/01/15/the-private-credit-boom
- Trepp. (2022). The rise of private credit & what it means for CRE finance. Retrieved from https://www.trepp.com/insights/blog/private-credit-rise-and-meaning-forCRE-finance
